Capital Assets

If you own property used in or owned by your business (other than Section 1231 property discussed in Chapter 6, or Section 1244 stock discussed later in this chapter), gain or loss on the disposition of the property generally is treated as capital gain or loss. Capital gains and losses are gains and losses taken on capital assets.

Most property is treated as capital assets. Excluded from the definition of capital assets are:

• Property held for sale to customers or property that will physically become part of merchandise for sale to customers (inventory)

• Accounts or notes receivable generated by your business (e.g., accounts receivable from the sale of inventory)

• Depreciable property used in your business, even if already fully depreciated (e.g., telephones)

• Real property used in your business (e.g., your factory)

• A copyright; literary or artistic composition; a letter or memorandum; or other similar property (e.g., photographs, tapes, manuscripts) created by your personal efforts or acquired from the creator by gift or in another transaction entitling you to use the creator's basis

• U.S. government publications

Under a special rule, self-created musical works qualify for capital asset treatment, if the musician so elects. Similarly, the cutting of standing timber may be treated as eligible for capital gain treatment (explained later in this chapter).

Determining the Amount of Your Gain or Loss

The difference between the amount received for your property on a sale, exchange, or other disposition, and your adjusted basis in the property is your gain or loss.

You adjust basis—upward or downward—for certain items occurring in the acquisition of the asset or during the time you hold it. Amounts that increase basis include:

• Improvements or additions to property.

• Legal fees to acquire property or defend title to it.

• Selling expenses (e.g., a real estate broker's fee or advertising costs).

• Unharvested crops sold with the land.

Amounts that decrease basis include:

• Amortized bond premiums.

• Cancellation of income adjustments (e.g., debt forgiveness because of bankruptcy or insolvency or on farm or business real property).

• Casualty losses that have been deducted (e.g., insurance awards and other settlements).

• Deductions for energy-efficient commercial buildings.

• Depletion allowances with respect to certain natural resources.

• Depreciation, amortization, first-year expensing, and obsolescence. (You must reduce the basis of property by the amount of depreciation that you were entitled to take even if you failed to take it.)

• Investment credit claimed with respect to the property. (The full credit decreases basis but one-half of the credit claimed after 1982 is added back for a net reduction of one-half of the credit.)

• Return of capital. (Dividends on stock are paid out of capital or out of a depletion reserve instead of earnings and profits or surplus.)

• Tax credit for alternative fuel vehicles and plug-in electric vehicles.

You do not adjust basis for selling expenses and related costs. These amounts are factored into the amount received (they reduce the amount received on the transaction).

Note: Overstating (inflating) the adjusted basis to minimize gain can result in tax penalties and extends the statute of limitations for audits to 6 years (from the usual 3 years) if the omission from gross income is more than 25%.

Sale or Exchange Requirement

In order to obtain capital gain or loss treatment on the disposition of a capital asset, you generally must sell or exchange property. Typically, you sell your property, but other transactions may qualify for sale or exchange treatment. For example, if your corporation redeems some or all of your stock, you may be able to treat the redemption as a sale or exchange. Capital losses are subject to limitation on current deductibility as explained later in this chapter.

If you dispose of property in some way other than a sale or exchange, gain or loss generally is treated as ordinary gain or loss. For example, if you abandon business property, your loss is treated as ordinary loss, even though the property is a capital asset. However, if the property is foreclosed on or repossessed, your loss may be a capital loss. If stock becomes worthless, this is treated as a capital loss. Ordinary losses are deductible without regard to the results from other transactions and can be used to offset various types of income (such as interest income).

Holding Period

Whether gains and losses are short-term or long-term depends on how long the asset disposed of has been held. If the holding period is more than 1 year, then gain or loss is long-term. If the holding period is 1 year or less, then the gain or loss is short-term.

If the business buys an asset, the holding period commences at that time (technically on the day after the acquisition date). If you transfer property to your business and the transfer is viewed as a nonrecognition transaction (for example, a tax-free incorporation), the company's holding period includes your holding period.

If a partnership makes an in-kind (property) distribution to you, include the partnership's holding period in your holding period. However, if the distribution is from the partnership's inventory, then you cannot add the partnership's holding period to yours if you sell the property within 5 years.

Tax-Free Exchanges

Gain need not be immediately reported as income if the transaction qualifies as a tax-free exchange. The term tax-free is not an entirely apt description because the tax rules for these transactions merely postpone the reporting of gain rather than make gain permanently tax free. You reduce the basis of the property you acquire in the exchange by the gain you realized on the trade but did not have to report. Then, when you later sell the replacement property in a taxable transaction, you will report the gain on both initial exchange and the later disposition (if any). There has been a proposal to eliminate tax-free exchange treatment, but nothing concrete has developed; check the Supplement for any update.

To qualify for the tax-free exchange treatment, both the old property (the property you are giving up) and the new property (the property you are acquiring, called replacement property) must be business or investment property (certain property cannot be exchanged tax free). And both of the properties must be of like kind. This means they must be of the same class of property. Depreciable tangible personal property can be either like kind or like class (the same General Asset Class or Product Class based on the 4-digit codes in the Industrial Classification Manual of the U.S. Department of Commerce). Examples of like-kind property include:

• Vacant lot for a factory building

• Factory building for an office complex

• City property for farmland

• Real estate owned outright for real estate subject to a lease of 30 years or more

• Pickup truck for a panel truck used in the business

• Telephone equipment for computer equipment used in the business

• Stock rights in water rights

The IRS has determined that intangibles, such as trademarks, trade names, newspaper mastheads, and customer-based intangibles, can be treated as like kind if they can be separately described and valued apart from goodwill.

If non-like-kind property is also received in the exchange, you must recognize gain to the extent of this other property, called boot.

Installment Sales

Gain need not be reported all at once if the sale is structured as an installment sale. This generally allows you to report gain as payments are received. An installment sale occurs when at least one payment is received after the year of sale.

Under the installment method, a portion of each payment received represents a return of your investment (part of your adjusted basis), and another part represents your profit (gain). You figure the amount of gain reported each year by a ratio:

Election Out of Installment Reporting

You can opt out of installment reporting and elect to report the entire gain in the year of sale (even though payments will be received at a later time). The election does not require any special forms. You simply report your entire gain in the year of sale. But once you do so, you generally cannot change your mind later on, even if your choice proved to be the wrong one taxwise.

Why would you want to report all of your gain in one year when you can spread it out over a number of years? Reporting the entire gain in the year of sale may be wise, for example, if you have a net operating loss carryforward that can be used to offset the gain.

Interest on Deferred Payments

Payments must bear a reasonable rate of interest. If you fail to fix a reasonable rate of interest, then a portion of each payment is deemed to represent interest rather than capital gain. Reasonable rate of interest usually is the applicable federal rate (AFR) of interest for the term of the installment sale. (Applicable federal rate is explained in Chapter 7.)

If the seller finances the purchase, the required minimum interest rate is the lower of 9% (“safe harbor rate”) compounded semiannually or the AFR, provided the financed amount does not exceed $5,664,800 in 2016. With interest rates running below the 9% safe harbor rate, charging the AFR will produce a lower allowable interest rate. If the deferred amount exceeds $5,664,800, then the required minimum interest rate is 100% of the AFR.

Depreciable Property

If you sell depreciable property on the installment basis, any depreciation recapture must be reported in full in the year of sale regardless of when payments are actually received. In other words, gain resulting from depreciation recapture may exceed the cash payments received in the year of the installment sale but must be reported as income anyway. Installment sales are also discussed in Chapter 2.

Short-Term Gain

This type of gain is subject to the same tax rates as ordinary income. Owners in a pass-through entity may pay different tax rates on the same share of short-term capital gain.

Unrecaptured Gain

Gain from the sale of real property on which straight line depreciation was taken results in unrecaptured gain (the amount of straight line depreciation). This portion of capital gain is taxed at the rate of 25% if the owner is in a tax bracket higher than the 15% tax bracket.

If property with unrecaptured gain is sold on the installment basis (discussed later in this chapter), then the first payment is deemed to reflect unrecaptured gain. When this amount has been fully reported, all additional amounts are capital gains subject to the lower rates detailed above.

Section 1202 Gain

Gain on the sale of Section 1202 stock (referred to as “small business stock”), which is stock in a C corporation that meets certain requirements, is partly or fully excludable. The exclusion depends on when the stock was acquired. Later in this chapter there is more on the sale of small business stock.

Capital Losses

Special rules determine how capital losses of individuals may be used. These rules are discussed later in this chapter.

Partnerships

Gain or loss on the sale of your partnership interest is treated as capital gain except to the extent any gain relates to unrealized receivables and inventory items. Gain in this case is ordinary income.

If you receive items that were inventory to the partnership, they may be treated as capital assets to you. However, if you dispose of the items within 5 years, then any gain with respect to these items is ordinary income, not capital gain.

LLCs

Generally, the rules governing the sale of a partnership interest apply with equal force to the sale of an interest in an LLC. However, there are 2 special situations to consider:

1. Sale of multiple-owner LLC to a single buyer. The entity is treated as hypothetically making a liquidating distribution of all of its assets to the sellers, followed by a deemed purchase by the single buyer of all the assets now hypothetically held by the sellers. The sellers then recognize gain or loss (depending on their basis in the LLC interests).

2. Sale of a single-member LLC to multiple buyers. This entity is treated as hypothetically selling its assets and then contributing them to the new entity comprised of multiple buyers (treated as a partnership). You recognize gain or loss on the deemed sale of your interest to the buyers. There is no gain or loss recognition upon the contribution of the assets to the new entity.

Deferring Gain

If you own Section 1202 stock in a small business for more than 6 months and sell it, you can defer any tax on the gain by acquiring other Section 1202 stock within 60 days of the sale. If you reinvest only part of your proceeds, you can defer gain to the extent of your reinvestment.

By making this rollover (called a Section 1045 rollover), the basis of the newly acquired stock is reduced by the gain that was not recognized on the initial sale.

Excluding Gain

If you own stock in a small business for more than 5 years and sell it, you can usually exclude some or all of your gain.

The amount of the exclusion depends on when the stock is acquired, and to some extent where the corporation is located.

• 50% exclusion. Stock acquired before February 18, 2009.

• 60% exclusion. Stock acquired in a corporation in an empowerment zone business where the 50% exclusion would otherwise apply. Empowerment zone businesses are explained in Chapter 7 with respect to the empowerment zone employment credit; the same definitions apply here. Of course, even if the stock is in an empowerment zone business, the higher exclusions that follow may apply instead of the 60% exclusion for stock acquired after February 17, 2009.

• 75% exclusion. Stock acquired after February 17, 2009, and before September 29, 2010.

• 100% exclusion. Stock acquired after September 28, 2010.

The amount of the exclusion related to stock from a particular company is limited to the greater of 10 times your basis in the stock or $10 million ($5 million if married filing separately) minus any gain on stock from the same company excluded in a prior year.

Deferring Gain from Publicly Traded Securities by Investing in a Specialized Small Business Investment Company

If you own publicly traded securities, gain from their sale can be deferred by rolling over the proceeds into qualified small business stock. In this case, qualified small business stock is stock or a partnership interest in a specialized small business investment company (SSBIC). The rollover must be completed within 60 days. The amount of the gain deferred under this option reduces the basis in the stock or partnership interest you acquire.

This deferral option is limited annually to $50,000 ($25,000 if married filing separately). This deferral option has a lifetime limit of $500,000 ($250,000 if married filing separately).

Qualifying for Ordinary Loss Treatment

The corporation issuing the stock must be a small business. This means that it can have equity of no more than $1 million at the time the stock is issued. This equity is the amount of cash or other property invested in the company in exchange for the stock. The stock must be issued for cash and property other than stock and securities. This definition of small business stock applies only to the loss deduction under Section 1244. Other definitions of small business stock apply for other purposes under the tax law.

You must acquire the stock by purchase. The ordinary loss deduction is allowed only to the original purchaser of the stock. If you inherit stock in a small business, receive it as a gift, or buy it from someone who was the original purchaser of the stock, you do not qualify for ordinary loss treatment.

Most important, the corporation must have derived over half its gross receipts during the 5 years preceding the year of your loss from business operations, and not from passive income. If the corporation is in business for less than 5 years, then only the years in which it is in business are considered. If the corporation's deductions (other than for dividends received and NOL) exceed gross income, the 5-year requirement is waived.

Limit on Ordinary Loss Deduction

You can treat only the first $50,000 of your loss on small business stock as an ordinary loss. The limit is raised to $100,000 on a joint return, even if only one spouse owned the stock. However, losses in excess of these dollar limits can be treated as capital losses, as discussed earlier in this chapter.

The ordinary loss deduction can be claimed only by individuals. If a partnership owns Section 1244 stock and sustains a loss, an ordinary loss deduction can be claimed by individuals who were partners when the stock was issued. If the partnership distributes stock to partners and the partners then realize a loss on the stock, they cannot treat the loss as an ordinary loss.

If an S corporation owns Section 1244 stock and sustains a loss, it cannot pass the loss through to its shareholders in the same way that partnerships can pass the loss through to their partners. Even though S corporation shareholders receive tax treatment similar to that of partners, one court that has considered this question concluded that the language of the tax law results in a difference in this instance. The denial of an ordinary loss deduction for Section 1244 stock is one important way in which the tax treatment differs between partnerships and S corporations.