Chapter 44
Sales of Business Property
On the sale of business assets, the tax treatment depends on the type of asset sold.
Inventory items: Profits are taxable as ordinary income; losses are fully deductible. Sales of merchandise are reported on Schedule C if you are self-employed or Schedule F if you are a farmer.
Depreciable property, such as buildings, machinery, and equipment: If you sell at a gain, the gain is taxable as ordinary income to the extent depreciation is recaptured (44.1–44.2). Any remaining gain may be treated as capital gain or ordinary income, depending on the Section 1231 computation (44.8). Losses may be deductible as ordinary losses (44.8). Sales are reported on Form 4797. Depreciable business equipment subject to recapture is described as a Section 1245 asset. Depreciable livestock is also a Section 1245 asset. Depreciable realty is generally described as a Section 1250 asset.
Land: If used in your business, capital gain or ordinary income may be realized under the rules of Section 1231 (44.8). If land owned by your business is held for investment, gain or loss is subject to capital gain treatment. Schedule D is used to report the sale of capital assets.
44.1 Depreciation Recaptured as Ordinary Income on Sale of Personal Property
On Form 4797, you report gain or loss on the sale of depreciable property. Gain realized on the sale of depreciable personal property (Section 1245 property) is treated as ordinary income to the extent the gain is attributed to depreciation deductions that reduced basis. In other words, the depreciation deductions are “recaptured” as ordinary income. If gain exceeds the amount of depreciation subject to recapture, the excess may be capital gain under Section 1231 (44.8).
Gain on the sale of real estate placed in service before 1987 may be subject to depreciation recapture (44.2).
Gain subject to recapture for Section 1245 property is limited to the lower of (1) the amount of gain on the sale (amount realized less adjusted basis) or (2) the depreciation allowed or allowable while you held the property. Generally, the depreciation deduction taken into account for each year is the amount allowed or allowable, whichever is greater. However, for purposes of figuring what portion of the gain is treated as ordinary income under the recapture rules (but not for purposes of figuring gain or loss), the depreciation taken into account for any year will be the amount actually “allowed” on your prior returns under a proper depreciation method, rather than the amount “allowable,” if the allowed deduction is smaller and you can prove its amount.
The adjusted basis of personal property depreciable under ACRS, such as business equipment and machinery, is fixed as of the beginning of the year of disposition. However, property depreciated under MACRS is subject to the convention rules so that partial depreciation under the applicable convention is allowed in the year of sale; this year of sale depreciation reduces adjusted basis.
44.2 Depreciation Recaptured as Ordinary Income on Sale of Real Estate
All or part of gain on the sale of depreciable real property may be attributable to depreciation deductions that reduced the basis of the property. On Form 4797, gain attributable to depreciation on Section 1250 realty placed in service before 1987 is subject to recapture as ordinary income unless straight-line depreciation was used. The amount of depreciation recapture depends on when the building was placed in service and whether it was residential or nonresidential; see below.
There is no ordinary income recapture for residential rental and nonresidential real property placed in service after 1986 because such properties are depreciated using the straight-line MACRS method (42.13). Previously claimed bonus depreciation is subject to recapture.
To the extent depreciation is not subject to ordinary income recapture, the gain on the sale is subject to the Section 1231 netting rules (44.8). If there is a net Section 1231 gain, the gain attributed to the depreciation is entered on the Unrecaptured Section 1250 Gain Worksheet in the Schedule D (Form 1040) instructions. The unrecaptured Section 1250 gain from that worksheet is subject to a top rate of 25% on the Schedule D Tax Worksheet included in the Schedule D instructions.
Recaptured depreciation. Ordinary income recapture may apply to Section 1250 realty placed in service before 1987. Section 1250 property includes buildings and structural components, except for elevators and escalators or other tangible property used as an integral part of manufacturing, production, or extraction, or of furnishing transportation, electrical energy, water, gas, sewage disposal services, or communications. Property may initially be Section 1250 property and then, on a change of use, become Section 1245 property (44.1). Such property may not be reconverted to Section 1250 property.
Depreciation claimed on realty placed in service after 1980 and before 1987. For real property placed in service after 1980 and before 1987 that was subject to ACRS, adjusted basis for computing gain or loss is the adjusted basis at the start of the year reduced by the ACRS deduction, if any, allowed for the year of disposition (based on number of months the realty is in service in disposition year; see 42.15). The recapture rules distinguish between residential and nonresidential property.
If the prescribed accelerated method is used to recover the cost of nonresidential property, all gain on the disposition of the realty is recaptured as ordinary income to the extent of recovery allowances previously taken. Thus, nonresidential realty will be treated in the same way as personal property (44.1) for purposes of recapture if the accelerated recovery allowance was claimed. If the straight-line method was elected, there is no recapture; all gain is subject to the netting rules of Section 1231 (44.8).
If accelerated cost recovery is used for a nonresidential building and straight-line depreciation is used for a substantial improvement to that building that you are allowed to depreciate separately (42.15), all gain on a disposition of the entire building is treated as ordinary income to the extent of the accelerated cost recovery claimed. Remaining gain is subject to the rules for Section 1231 assets (44.8).
For residential real estate, 100% of the excess depreciation claimed is subject to recapture. That is, there is ordinary income recapture to the extent the depreciation allowed under the prescribed accelerated method exceeds the recovery that would have been allowable if the straight-line method over the ACRS recovery period had been used. If the straight-line method was elected, there is no recapture. All gain is subject to Section 1231 netting (44.8).
For low-income rental housing, the percentage of excess depreciation (over straight-line) subject to recapture is 100% minus 1% for each full month the property was held over 100 months, so there is no recapture of cost recovery deductions once the property was held at least 200 months (16 years and 8 months). If you dispose of low-income housing with separate improvements, or with units placed in service at different times, the amount of excess depreciation must be computed separately for each element. See IRS Publication 544 for details on the recapture rules for low-income housing.
Different recapture rules applied to depreciation on realty placed in service before 1981.
44.3 Recapture of First-Year Expensing
On Form 4797, the first-year expensing deduction (Section 179 deduction (42.3)) is treated as depreciation for purposes of recapture. When expensed property is sold or exchanged, gain is recaptured as ordinary income (44.1) to the extent of the first-year expense deduction plus ACRS or MACRS deductions and bonus depreciation (42.20), if any. If the entire cost of the property was expensed, adjusted basis will generally be reduced to zero, gain on a sale or exchange will equal the sales price (less expenses), and the entire gain will be recaptured as ordinary income.
Expensing deductions are also subject to recapture if property placed in service after 1986 is not used more than 50% of the time for business in any year before the end of the recovery period. The amount recaptured is the excess of the first-year expensing deduction over the amount of depreciation that would have been claimed in prior years and in the recapture year without expensing.
Automobiles and other “listed property.” If the more-than-50%-business-use test for a business automobile or other “listed property” such as certain computers (42.10) is not met in a year after the auto or other “listed property” is placed in service and before the end of the recovery period, any first-year expensing deduction is subject to recapture on Form 4797; see the Example at 43.10.
44.4 Gifts and Inheritances of Depreciable Property
Gifts and charitable donations of depreciable property may be affected by the recapture rules. On the gift of depreciable property, the ordinary income potential of the depreciation carries over into the hands of the donee. When the donee later sells the property at a profit, he or she will realize ordinary income (44.1).
On the donation of depreciable property, the amount of the charitable contribution deduction is reduced by the amount that would be taxed as ordinary income had the donor sold the equipment at its fair market value.
The transfer of depreciable property to an heir through inheritance is not a taxable event for recapture purposes. The ordinary income potential does not carry over to the heir because his or her basis is usually fixed as of the date of the decedent’s death.
Important: A gift of depreciable property subject to a mortgage may be taxed to the extent that the liability exceeds the basis of the property (14.6, 31.15).
44.5 Involuntary Conversions and Tax-Free Exchanges
Involuntary conversions. Gain may be taxed as ordinary income in either of the following two cases: (1) you do not buy qualified replacement property or (2) you buy a qualified replacement, but the cost of the replacement is less than the amount realized on the conversion (18.23). The amount taxable as ordinary income may not exceed the amount of gain that is normally taxed under involuntary conversion rules when the replacement cost is less than the amount realized on the conversion. Also, the amount of ordinary income is increased by the value of any nondepreciable property that is bought as qualified replacement property, such as the purchase of 80% or more of stock in a company that owns property similar to the converted property.
Distributions by a partnership to a partner. A distribution of depreciable property by a partnership to a partner does not result in ordinary income to the distributee at the time of the distribution. But the partner assumes the ordinary income potential of the depreciation deduction taken by the partnership on the property. When he or she later disposes of the property, ordinary income may be realized.
44.6 Installment Sale of Depreciable Property
All depreciation recapture income (including the first-year expensing deduction) is fully taxable in the year of sale, without regard to the time of payment. Recapture is figured on Form 4797. On Form 6252, the gain in excess of the recapture income is reported under the installment method (5.21).
44.7 Sale of a Proprietorship
The sale of a sole proprietorship is not considered as the sale of a business unit but as sales of individual business assets. Each sale is reported separately on your tax return.
A purchase of a business involves the purchase of various individual business assets of the business. To force buyers and sellers to follow the same allocation rules, current law requires both the buyer and the seller to allocate the purchase price of a business among the transferred assets using a residual method formula. Allocations are based on the proportion of sales price to an asset’s fair market value and they are made in a specific order set out on Form 8594.
44.8 Property Used in a Business (Section 1231 Assets)
Form 4797 is used to report the sale or exchange of Section 1231 assets. The following properties used in a business are considered “Section 1231 assets”:
• Depreciable assets such as buildings, machinery, and other equipment held more than one year. Depreciable rental property and royalty property fits in this category if held more than one year.
• Land (including growing crops and water rights underlying farmland) held more than one year.
• Timber, coal, or domestic iron ore subject to special capital gain treatment.
• Leaseholds held more than one year.
• An unharvested crop on farmlands, if the crop and land are sold, exchanged, or involuntarily converted at the same time and to the same person and the land has been held more than one year. Such property is not included here if you retain an option to reacquire the land.
• Cattle and horses held for draft, breeding, dairy, or sporting purposes for at least 24 months.
• Livestock (other than cattle and horses) held for draft, breeding, dairy, or sporting purposes for at least 12 months. Poultry is not treated as livestock for purposes of Section 1231.
Section 1231 netting. On Form 4797, you combine all losses and gains, except gains allocated to depreciation recapture, from:
- • The sale of Section 1231 assets (from the list at the beginning of this section).
- • The involuntary conversion of Section 1231 assets and capital assets held for more than one year for business or investment purposes. You include casualty and theft losses incurred on business or investment property held for more than one year. However, there is an exception if losses exceed gains from casualties or thefts in one taxable year.
Caution
Result of netting. A net gain on Section 1231 assets from Form 4797 is entered on Schedule D as a long-term capital gain unless the recapture rule (see the second Caution on this page) for net ordinary losses applies. A net loss on Section 1231 assets is treated as an ordinary loss that is combined on Form 4797 with ordinary income from depreciation recapture (44.1) and with ordinary gains and losses from the sale of business property that does not qualify for Section 1231 netting.
Installment sale. Gain realized on the installment sale of business or income-producing property held for more than a year may be capital gain one year and ordinary income another year. Actual treatment in each year depends on the net result of all sales, including installment payments received in that year (44.6).
Losses exceed gains from casualties or thefts. On Form 4684, you must compute the net financial result from all involuntary conversions arising from fire, storm, or other casualty or theft of assets used in your business and capital assets held for business or income-producing purposes and held more than one year. The purpose of the computation is to determine whether these involuntary conversions enter into the above Section 1231 computation. If the net result is a gain, all of the assets enter into the Section 1231 computation. If the net result is a loss, then these assets do not enter into the computation; the losses are deducted separately as casualty losses, and the gains reported separately as ordinary income. If you incur only losses, the losses similarly do not enter into the Section 1231 computation.
44.9 Sale of Property Used for Business and Personal Purposes
One sale will be reported as two separate sales for tax purposes when you sell a car or any other equipment used for business and personal purposes, or in some cases where a sold residence (29.7) was used partly as a residence and partly as a place of business or to produce rent income.
You allocate the sales price and the basis of the property between the business portion and the personal portion. The allocation is based on use. For example, with a car, the allocation is based on mileage used in business and personal driving.
44.10 Should You Trade in Business Equipment?
The purchase of new business equipment is often partially financed by trading in old equipment. For tax purposes, a trade-in may not be a good decision. If the market value of the equipment is below its adjusted basis, it may be preferable to sell the equipment to realize an immediate deductible loss. You may not deduct a loss on a trade-in. However, if you do trade, the potential deduction reflected in the cost basis of the old equipment is not forfeited. The undepreciated basis of the old property becomes part of the basis of the new property and may be depreciated. Therefore, in deciding whether to trade or sell where a loss may be realized, determine whether you will get a greater tax reduction by taking an immediate loss on a sale or by claiming larger depreciation deductions.
If the fair market value of the old equipment exceeds its adjusted basis, you have a potential gain. To defer tax on this gain, you may want to trade the equipment in for new equipment. Your decision to sell or trade will generally be based on a comparison between (1) tax imposed on an immediate sale and larger depreciation deductions taken on the cost basis of the new property, and (2) the tax consequences of a trade-in in which the tax is deferred but reduced depreciation deductions are taken on a lower cost basis of the property. In making this comparison, you will have to estimate your future income and tax rates. Also pay attention to the possibility that gain on a sale may be taxed as ordinary income under the depreciation recapture rules (44.1).
The tax consequences of a trade-in may not be avoided by first selling the used property to the dealer who sells you the new property. The IRS will disregard the sale made to the same dealer from whom you purchase the new equipment. The two transactions will be treated as one trade-in.
44.11 Corporate Liquidation
Liquidation of a corporation and distribution of its assets for your stock is generally subject to capital gain or loss treatment. For example, on a corporate liquidation, you receive property worth $10,000 from the corporation. Assume the basis of your shares, which you have held long term, is $6,000. You have realized a long-term gain of $4,000.
If you incur legal expenses in pressing payment of a claim, you treat the fee as a capital expense, according to the IRS. The Tax Court and an appeals court hold that the fee is deductible as an expense incurred to earn income; the deduction is subject to the 2% of adjusted gross income (AGI) floor (19.1).
If you recover a judgment against the liquidator of a corporation for misuse of corporate funds, the judgment is considered part of the amount you received on liquidation and gives you capital gain, not ordinary income.
If you paid a corporate debt after liquidation, the payment reduces the gain realized on the corporate liquidation in the earlier year; thus, in effect, it is a capital loss.
If the corporation distributes liquidating payments over a period of years, gain is not reported until the distributions exceed the adjusted basis of your stock.
44.12 Additional Taxes on Higher-Income Taxpayers
Self-employed individuals who sell business property and who have “high-income” may be subject to additional taxes that are intended to help pay for health care reform. If your income exceeds the applicable threshold for your filing status, you may be subject to either or both of these taxes:
• An additional 0.9% Medicare tax on net earnings from self-employment (28.2).
• An additional 3.8% tax on net investment income (NII tax) (28.3).
When are sales of business property treated as earned income (for the 0.9% tax) or investment income (for the 3.8% tax)? The following guidance should be applied to determine whether the additional taxes apply:
• Active businesses. Self-employed people who are active in their businesses do not treat gains from the sale of business assets as subject to either the 0.9% tax (the gains are not part of net earnings from self-employment) or the 3.8% tax (the gains are from a business, not an investment).
• Passive activities. Those who are not active in their businesses (i.e., they are passive investors) treat taxable gains from the sales of business property as investment income for purposes of the 3.8% tax. This assumes that the business is a passive activity because the self-employed person does not meet the material participation tests (10.6); see Chapter 10 for details on the passive activity rules.
44.1 Depreciation Recaptured as Ordinary Income on Sale
of Personal Property 735
44.2 Depreciation Recaptured as Ordinary Income on Sale
of Real Estate 735
44.3 Recapture of First-Year Expensing 736
44.4 Gifts and Inheritances of Depreciable Property 736
44.5 Involuntary Conversions and Tax-Free Exchanges 737
44.6 Installment Sale of Depreciable Property 737
44.7 Sale of a Proprietorship 737
44.8 Property Used in a Business (Section 1231 Assets) 737
44.9 Sale of Property Used for Business and Personal Purposes 738
44.10 Should You Trade in Business Equipment? 739
44.11 Corporate Liquidation 739
44.12 Additional Taxes on Higher-Income Taxpayers 740
See also:
29.7 Personal and Business Use of a Home
29.9 Loss on Residence Converted to Rental Property
40.27 Filing Schedule F (farm income)