CHAPTER 6
Gains and Losses from Sales of Business Property
- Section 1231 Gains and Losses
- Sale-Leasebacks
- Installment Sales
- Recapture
- Involuntary Conversions
- Abandonment, Foreclosure, and Repossession of Property
- Sale of All the Assets of the Business
Businesses hold a unique category of assets called Section 1231 property. This category is named after the section in the Internal Revenue Code that created them. Upon the disposition of these assets, you can realize the best of both possible worlds—capital gain treatment for profitable sales and ordinary loss treatment for sales that result in a loss. Gain may be recognized all at once or deferred through an installment sale.
You may also realize gains or losses from other transactions involving business property, including involuntary conversions, abandonment or repossession of property, or the sale of all of the assets of the business.
Complex rules govern the overall treatment of these transactions. (The treatment of capital gains and losses from other property is also discussed in Chapter 5.) The purpose of this chapter is to alert you to the basic rules governing certain sales of business property. If any transaction applies to your business, you may wish to delve deeper with the assistance of a tax professional.
For further information about capital gains and losses, see IRS Publication 537, Installment Sales, and IRS Publication 544, Sales and Other Dispositions of Assets.
Section 1231 Gains and Losses
Certain assets used in business are granted special tax treatment. This treatment seeks to provide a win-win situation for a business. If a sale or other disposition of these assets (called Section 1231 property) results in a net gain, the gain can be treated as capital gain. If a net loss results, the loss is an ordinary loss.
Examples of Section 1231 property include:
Real property and depreciable personal property (such as equipment)
Leaseholds
Timber, coal, and iron ore
Certain livestock and unharvested crops
Gains or losses due to casualty, theft, or condemnation may also be treated as Section 1231 gains or losses if the property was held for more than one year. Also, the payment from a manufacturer to a distributor to cancel the distributor agreement is treated as a long-term capital gain, provided the distributor made a substantial capital investment in the distributorship and the investment is reflected in physical assets.
Section 1231 property does not include:
Inventory or other property held for sale to customers
Copyrights; literary, musical (unless a special election is made, as explained in Chapter 5), or artistic compositions; letters or memoranda; or similar property created by your efforts
Government publications
Determining Section 1231 Gains or Losses
You must use a netting process to determine your Section 1231 gains or losses. This means combining all gains and losses from the sale or other disposition of Section 1231 property. If your Section 1231 gains exceed your Section 1231 losses, then all of your gains and losses are treated as capital gains and losses. In contrast, if your Section 1231 losses equal or exceed your Section 1231 gains, all of your gains and losses are treated as ordinary gains and losses.
If you sell appreciated Section 1231 property to a related party, gain that would otherwise be capital gain is recharacterized as ordinary income if the property is depreciable property in the hands of the buyer. Related parties for this purpose means a person and all entities that are controlled entities. A controlled entity is:
A corporation with more than 50% of the value of the outstanding stock that is owned, directly or indirectly, by you.
A partnership with more than 50% of the capital interest or profits interest that is owned, directly or indirectly, by you.
Two corporations that are members of a controlled group.
A corporation and a partnership if the same person owns more than 50% of the value of the stock and more than 50% of the capital interest or profit interest in the partnership.
An S corporation and another S corporation where the same person owns more than 50% of each.
Losses
The fact that your Section 1231 losses for the year equal or exceed Section 1231 gains does not automatically ensure ordinary loss treatment. You must check to see whether a special recapture rule applies. Under the recapture rule, net Section 1231 gain is treated as ordinary income to the extent it does not exceed nonrecaptured net Section 1231 losses taken in prior years.
The recapture rules for Section 1231 gains and losses are extremely complex. They are designed to prevent you from being able to time gains and losses from year to year so that you take your gains as capital gains and your losses as ordinary losses. (Do not confuse these recapture rules with those that apply to depreciation, which are discussed later in this chapter.) The recapture rules, in effect, treat your gains and losses as occurring in the same year so that what would ordinarily have been treated as capital gains is partially or fully treated as ordinary income.
Losses are recaptured beginning with the earliest year subject to recapture.
Sale-Leasebacks
A sale-leaseback is an arrangement in which an owner of business realty sells the property to a buyer or transfers it to a trust and then leases the property back for use in the business. The lease usually runs long term (e.g., 10 or 15 years); however, a lease term of 20 years or more can trigger unwanted tax results. The following information relates solely to a sale (transfers to a trust are not considered here). The arrangement is not new but has garnered considerable media attention in recent years with many large public corporations, including Darden Restaurants (operator of Olive Garden, LongHorn Steakhouse, and Capital Grille), Bob Evans Farms (owner of Bob Evans restaurants), Sharp Electronics Inc., and various Verizon operation centers, using it.
Seller Perspective
The arrangement is largely viewed as a financing arrangement because the seller unleashes the otherwise illiquid equity that has been built up. The funds are then used to pay down debt on the property, other business debt, or for any other purpose. Aside from the financial aspects of the arrangement, disposing of the realty allows the company to focus on its core business rather than have to divert some attention to maintaining the property.
From a tax point of view, the sale of the realty usually qualifies for Section 1231 treatment, explained earlier in this Chapter. It is a way to generate capital gain that can be used to offset capital losses that have been realized from other transactions.
Buyer Perspective
For the buyer, the lease payments usually are structured to closely match the costs of ownership, including debt service and other expenses. The lease may be set up so that the seller pays taxes on the property. The buyer becomes a landlord, and can deduct rental-related expenses (including depreciation on the reality as explained in Chapter 14).
Installment Sales
If you sell property and receive at least one payment after the year of sale, you have automatically transacted an installment sale. You report your gain over the period in which you receive payment unless you elect to report all of the gain in the year of sale. Installment reporting does not apply to losses. This is called the installment method. You can use it regardless of your other accounting method for reporting income. Installment reporting does not affect the amount of gain you report, nor the characterization of that gain. It merely affects the timing of reporting the gain.
Installment reporting is explained in greater detail in Chapter 2.
Recapture
If part of the gain on an installment sale relates to depreciation recapture, this gain must be reported up front, regardless of the payments received.
Recapture
Certain write-offs you may take can come back to haunt you. The benefit you enjoy now may have to be repaid at a later time. For instance, if you claim certain depreciation on business assets (explained in Chapter 14)—a write-off of the cost of the assets over a set time—you must recapture the benefit when you dispose of the assets. Recapture in some instances is merely a matter of recharacterizing gain—instead of capital gain, the recapture amount is treated as ordinary income. However, in other instances, recapture means reporting income that would not otherwise be due.
Most of the following discussion about recapture applies only to businesses other than C corporations. The reason: C corporations do not have favorable tax rates on capital gains. There is, however, one recapture rule specifically for C corporations, which is explained later in this chapter.
Recaptured Depreciation
If you claim accelerated depreciation on realty (generally this applies to realty placed in service before 1987), then you must recapture (report as ordinary income) the portion of gain relating to the excess of accelerated depreciation.
For equipment and other personal property, recapture all of depreciation claimed (to the extent of gain).
For nonresidential realty depreciated under the Accelerated Cost Recovery System (ACRS) (placed in service after 1981 and before 1987), recapture the excess of ACRS depreciation in excess of straight-line depreciation. Different rules apply to pre-ACRS property.
Unrecaptured Depreciation
If you claim a home office deduction for business use of a portion of your home (these rules are explained in Chapter 18), you do not have to apportion your gain; in effect, you can apply the home sale exclusion to your entire gain. However, all depreciation claimed on a home office after May 6, 1997, is unrecaptured depreciation—it must all be reported as gain upon the sale of the home. This gain is taxed at a maximum of 25%.
Recapture on Installment Reporting
When to report recapture on an installment sale depends on the type of recapture involved:
For recaptured depreciation—All of the depreciation must be reported in full in the year of sale. This recapture is reported without regard to the proceeds received in the year of sale.
For unrecaptured depreciation—The gain, with respect to each installment payment received, is reported first at the 25% rate. Once unrecaptured depreciation has been fully reported, the balance of any gain is reported at the basic capital gains rate (generally 15% for owners of pass-through entities, but 20% for owners who are in the 39.6% tax bracket).
Involuntary Conversions
Special Recapture by C Corporations
When a C corporation sells depreciable realty, such as a factory or office building, 20% of the gain (referred to in tax parlance as unrecaptured gain) is characterized as ordinary income rather than capital gain. While this does not impact the regular income tax of a C corporation because it pays the same tax rate on ordinary income and capital gain, it can impact the corporation's alternative minimum tax (AMT) if the business is subject to this tax. As a practical matter, since small C corporations are exempt from the corporate AMT, this recapture rule is not likely to impact a small business set up as a C corporation.
If business property is destroyed or stolen, condemned or disposed of through threat of condemnation and you receive insurance proceeds or other funds to compensate you for your loss, you have suffered an involuntary conversion. Condemnations are the taking of your property for public purposes, such as building roads or putting up utility poles—in effect a forced sale. Threat of condemnation occurs when you learn from a government official or other authorized person that the government intends to take your property. If you do not sell it to the government, it will be condemned.
If the funds you receive for the involuntary conversion of your property exceed your adjusted basis in the involuntarily converted property, you have a gain that is currently taxable unless you qualify to postpone your gain (explained later). If the funds you receive are less than your adjusted basis in the involuntarily converted property, you have a loss that is currently deductible (subject to usual loss limitation rules discussed in this chapter and in Chapter 5).
In reporting condemnation awards, you can reduce your receipts by any legal fees or other expenses you incurred to obtain the payment as well as any special assessments levied against the part of the property if only a portion of the property was condemned. If amounts are withheld from the award to pay off your mortgage or outstanding taxes, you treat these amounts as payment you receive. Also add to the amount any severance payments you receive for the decrease in the value of the property you retain if only a portion of the property was condemned. The portion of gain relating to severance damages can be postponed in the same way as direct payments for the condemned property.
In figuring your gain or loss from an involuntary conversion, certain payments related to the event are not taken into account (they are treated separately):
Relocation payments from the federal government or an assistance program. If you are displaced from your business (including a home in which you maintain a home office) or farm, you may be eligible for these funds. These amounts are tax-free payments.
Interest on a condemnation award. The municipality may pay you out over time, plus interest. This interest is reported separately as interest income (see Chapter 4).
Election to Postpone Gain
You make the election to postpone gain by acquiring replacement property within set time limits. In deciding whether or not to postpone gain, keep in mind that you do not have to use the insurance proceeds or other funds to acquire the replacement property—you need only invest a similar amount. You can, for example, spend the proceeds and take a loan to buy the replacement property. First, consider the advantage and disadvantage to help you decide whether or not you want to postpone gain.
Advantage—Postponing gain allows you to use the proceeds undiminished by taxes on your gain.
Disadvantage—You must reduce the basis of the replacement property by the amount of gain not immediately recognized. This results in a lower basis for purposes of figuring depreciation on the replacement property as well as for determining gain or loss on the disposition of the property.
Replacement Property
Replacement property is property that is similar or related in service or use to the involuntarily converted property. Similar or related means that the functions of the old and replacement properties are related. For example, if one piece of machinery is destroyed in a storm and you buy a new machine to perform the same work in your business, the new machine is clearly replacement property.
You need not buy the property directly. You are treated as acquiring replacement property if you buy at least an 80% interest in a corporation that owns property similar or related in service or use to the involuntarily converted property. However, you cannot buy replacement property from a related party—a business you control or a close relative—if the gain is more than $100,000. You can buy replacement property from a related party if the gain is $100,000 or less.
If your business property is destroyed in a disaster within an area qualifying for federal disaster relief, acquiring any tangible property for your business is treated as similar or related, even if the functions of the old and new property are entirely different.
Replacement Time Limits
You must decide whether or not to postpone gain by acting with set time limits to place replacement property in service for your business. Generally, you have until the end of the 2 years following the close of the year in which gain from the involuntary conversion was realized to acquire replacement property. For property involuntarily converted after certain major catastrophes (such as Hurricane Katrina), the replacement period may be extended to 5 years. Similar extensions can be granted for other disasters; check the IRS' Tax Relief in Disaster Situations at www.irs.gov/uac/Tax-Relief-in-Disaster-Situations.
If business property has been condemned (or sold under threat of condemnation), the replacement period is 3 years from the close of the year in which the gain from condemnation (or threat of condemnation) was realized. However, if you buy replacement property by acquiring a controlling interest in a corporation, then the 2-year replacement period applies.
If you decide you want to postpone gain but time is running out on buying replacement property, you can request an extension. For example, if you have already found property but have yet to close on the sale, ask for more time to do so. Address your request to the local district director of the IRS. Do not let the replacement period expire without submitting your extension request—it may be almost impossible to obtain an extension at this late date.
Abandonment, Foreclosure, and Repossession of Property
Disposing of business property by abandonment, foreclosure, or repossession generally produces taxable results.
Abandonment
If you abandon business property, you automatically have a loss that is treated as an ordinary loss. The amount of your loss is the adjusted basis of the abandoned property. However, if you effectively abandon inventory that has become unsalable because it is obsolete or defective, you do not report it as a loss. Instead, you adjust your inventory valuation to reflect the actual value of the items, which may be merely their scrap value.
If the property you are abandoning is subject to a debt for which you are personally liable and the debt is canceled, you have ordinary income to the extent of this debt cancellation. Report this income separately from the abandonment loss—do not net one against the other. (Income from the cancellation of debt is also discussed in Chapter 4.)
Foreclosure or Repossession
If you cannot pay a loan or the mortgage on your business property, the lender will recoup this amount by foreclosing on the property or repossessing it. Foreclosure and repossession are treated as a sale or exchange for tax purposes, producing a gain or loss on the transaction. This is the case even if you voluntarily transfer the property back. The amount realized usually is the debt you no longer have to pay. The difference between this amount and the adjusted basis in the property is the amount of your gain or loss.
If the debt is recourse debt (you are personally liable for it)—do not include the debt cancellation in the amount realized (you report the debt cancellation separately as income as explained in Chapter 4). Exception: If the value of the property is less than the canceled debt, then the amount realized includes the debt cancellation to the extent of the value of the property.
If the debt is nonrecourse debt (you are not personally liable for it)—include the full debt cancellation in the amount realized, regardless of the property's value.
Lender's Perspective
If you are the lender and foreclose or repossess property because of nonpayment, you recognize gain or loss on the transaction. This is so whether or not the debtor cooperates and voluntarily transfers the property back to you.
Real Property
Generally, your gain is the difference between the total payments you have already received for the property and the gain you already reported as income. However, your reportable gain on a foreclosure or repossession is limited to the gross profit on your original gain minus any gain already reported. Reduce your profit by any costs related to the foreclosure or repossession, such as legal fees, court costs, and costs of recording or clearing title to the property.
Your basis in the reacquired property is your original basis in the property, increased by any gain recognized on the receipt of principal and foreclosure/ repossession, and decreased by any principal payments received.
Equipment and Other Personal Property
If you sold property on the installment method and repossess it for nonpayment, report gain or loss on the transaction. In review, gain or loss is the difference between your basis in the installment obligations and the value of the property you repossess. Reduce the basis in the installment obligations by any costs for the repossession. Increase the value of the property by anything you receive from the debtor upon the repossession, such as a partial payment.
What is your basis in the installment obligations? This depends on how you originally opted to report the sale. If you used the installment method, your basis in the installment obligations is the unpaid balance of the installment obligations divided by your gross profit percentage.
Sale of All the Assets of the Business
If you sell your business, such as a sole proprietorship, by selling all of its assets, the rules for reporting gain or loss are really no different from a single-asset sale. You allocate the purchase price of the sale to each of the assets, including goodwill or going concern value, in order to determine your gain or loss. You usually arrive at this allocation through negotiations between you and the buyer.
Asset classes reported on Form 8594, Asset Acquisition Under Section 1060, include the following:
Class I assets—Cash, and savings and checking accounts.
Class II assets—Certificates of deposit, government securities, publicly traded stock or securities, and foreign currency.
Class III assets—Mark-to-market assets.
Class IV assets—Stock in trade and inventory.
Class V assets—All assets that do not fall within another class. Furniture and fixtures, buildings, land, vehicles, and equipment generally fall within this class.
Class VI assets—Section 197 assets (other than goodwill and going concern value) such as patents, copyrights, licenses, permits, franchises, trademarks, and covenants not to compete. (Section 197 assets are discussed in Chapter 14.)
Class VII assets—Goodwill and going concern value.
The sale price is allocated in descending order—first to Class I assets, then Class II assets, and so on. There is no debate on allocating part of the purchase price to assets in the first 2 classes since the value of the assets is not in dispute. But as a seller, you generally want to allocate as much of the remaining purchase price to assets that will produce the most favorable tax results to you. For example, if you can allocate an amount to goodwill, you will achieve capital gain treatment.
In contrast, if such an amount is allocated to inventory, you have ordinary income. However, the buyer has competing interests and wants to allocate as much as possible to depreciable assets. That would give him or her the opportunity to maximize depreciation deductions. Ultimately, the price you receive for the assets will reflect negotiations that include the allocation process.
Corporations that acquire stock in another corporation may, under certain circumstances, elect to treat the stock purchase as an asset sale (see Chapter 5).
For All Taxpayers
Section 1231 gains and losses are reported on Form 4797, Sales of Business Property, regardless of the type of entity. The results from Form 4797 are carried over and reported on the business's tax return. For individuals, Form 4797 gains and losses are reported directly on Form 1040.
Installment sales are figured on Form 6252, Installment Sale Income. The results are carried over to Form 4797 (or Form 8949 and Schedule D as explained in Chapter 5). Use a separate Form 6252 for each installment sale you transact. Do not complete the form if you elect out of installment reporting—instead simply report your entire gain on Form 4797 (or Form 8949 and Schedule D).
A sale of all the assets of the business is reported on Form 8594, Asset Acquisition Statement. This form is used to allocate the purchase price to specific assets.
Self-Employed
Gains and losses on Section 1231 property are reported on Form 4797. The results are carried over to page 1 of Form 1040. Do not enter the results on Schedule C (or on Schedule F in the case of farming operations).
If you elect to postpone gain on a casualty, theft, or condemnation, make your election on the return for the year in which you realized gain. If you acquired replacement property before filing your return, attach a statement to the return showing the amount realized, how you computed your gain, and any gain reported. If you have not yet acquired replacement property by the time you must file your return, simply attach a statement to your return showing the circumstances of the casualty, theft, or condemnation giving rise to the gain, how you calculated your gain, and that you intend to acquire replacement property within the replacement period. Then, when you do buy replacement property, attach another statement to the return for the year of the replacement purchase explaining the replacement.
If the replacement period expires before you acquire replacement property (and you do not obtain an extension for the replacement period), you must file an amended return for the year in which you realized gain. You report your full gain on this amended return. You must also file an amended return if you buy replacement property and the cost is not sufficient to postpone the reporting of all of your gain. You report the portion of the gain not covered by the replacement property on this amended return.
Once you have designated certain property as your replacement property, you cannot later substitute other property for it. However, if your replacement property is found to be unsuitable, you can then substitute other qualified property, provided the replacement period has not expired.
Partnerships and LLCs
Section 1231 gains and losses are calculated on Form 4797 and then entered on Schedule K and allocated to partners on Schedule K-1.
If there is a gain as a result of a casualty or theft to business property, the partnership or LLC must elect to defer the recognition of gain and buy the replacement property. The individual partners or LLC members cannot make a separate election. Each partner or LLC member reports his or her distributive share of business income or loss on his or her personal income tax return.
S Corporations
Section 1231 gains and losses are computed on Form 4797 and then entered on Schedule K and allocated to shareholders on Schedule K-1.
If there is a gain as a result of a casualty or theft to business property, the S corporation must elect to defer the recognition of gain and buy the replacement property. The individual shareholders cannot make a separate election. Each shareholder reports his or her distributive share of S corporation income or loss on his or her personal income tax return.
C Corporations
Section 1231 gains and losses are computed on Form 4797 and then entered on Form 1120. Both capital losses and Section 1231 losses are part of the corporation's taxable income.
If the corporation discovers that it suffered a loss from worthless securities in a prior year and wants to file an amended return, use Form 1120X, Amended U.S. Corporation Income Tax Return.