Over the past several years many companies pursued extremely aggressive growth, resulting in an accumulation of fixed assets on balance sheets. Many of these assets (especially land and buildings) have enjoyed an unprecedented appreciation in value. However, the current recession and accompanying credit crunch have caught some companies in a crisis of having to raise cash or face going out of business. For example, among the measures General Motors Corp. was considering in late 2008 to stave off bankruptcy was a plan to sell its new corporate headquarters in the landmark Renaissance Center in Detroit for approximately $500 million and to rent facilities there instead.
The credit crunch has also dramatically affected small businesses. In a survey of small and midsize businesses, the National Small Business Association found that two-thirds of the respondents had been affected by the credit crunch, with more than 30% indicating a decline in the conditions surrounding traditional bank loans. In fact, over half of the respondents leveraged their loans using credit cards, personal savings and home equity. As the economic downturn and credit crunch continue, asset leasing, combined with the disposal of selected assets, will be viewed as an increasingly viable option to improve cash flows.
Properly managing taxation of gains and losses on the disposal of such assets requires careful planning and analysis even in the best of times to maximize cash flows. Normally, it’s to your clients’ advantage to treat a taxable gain as long–term capital gain, to which lower rates apply, and a loss as an ordinary loss, because it can be used to offset ordinary income. That’s exactly what IRC § 1231 allows. It covers the sale or exchange of both depreciable and real property held for more than one year that has been used in a trade or business. Also included is property involuntarily converted via destruction, theft, seizure or condemnation.
A client’s failure to take advantage of these provisions can result in higher taxes and, thus, in reduced after–tax cash flows. As this article shows, however, rules governing recapture of net ordinary losses and depreciation complicate the picture. CPAs can help businesses make the most of section 1231 by timing the sale or disposal of assets to overcome these hurdles.
For many companies, the importance attached to the disposal of capital assets has increased dramatically due to the forced sell–off of noncore assets to raise cash. In essence, companies are being forced to squeeze cash from the balance sheet. Planning and timing, to the extent possible, can enhance cash flows by turning what would be ordinary income under section 1221 from the sale of these business assets into potential long–term capital gain under section 1231. Moreover, these section 1231 gains can be netted with other long–term capital gains or losses at yearend, and with gains perhaps being offset by losses characteristic of a forced sale of other assets. If the netting process results in a net loss, section 1231(a)(2) specifies that the gains and losses shall not be treated as gains and losses from sales and exchanges of capital assets; therefore, the individual gains and losses are treated as ordinary gains and losses.
Exhibits 1 and 2 illustrate the tax savings available as a result of this favorable treatment. Keep in mind that under current law for tax years 2009 and 2010, taxpayers in the 10% and 15% marginal ordinary income tax brackets pay no tax on net long–term capital gains, and taxpayers in the 25% , 28% , 33% and 35% brackets pay a maximum rate of 15%
While section 1231 appears to provide taxpayers with the best of both worlds, the Code imposes two restrictions that limit this favorable treatment: (1) section 1231(c) recapture of net ordinary losses (“lookback” rule), which prevents the tax benefits obtained from clustering gains and losses, and (2) the depreciation recapture provisions of sections 1245 and 1250 that convert all or part of what otherwise would be section 1231 gain into ordinary income. Corporate taxpayers must also contend with section 291 recapture.
The lookback rule requires taxpayers to recapture as ordinary income any of the current year’s net section 1231 gain to the extent that net section 1231 losses have been deducted in the preceding five years. Thus, while the lookback rule does not affect the amount of the gain, it does affect the character—ordinary income or capital gain. Exhibit 3 demonstrates the loss of tax savings due to the lookback rule. However, careful timing of the disposal of section 1231 assets can mitigate this problem, as illustrated in Exhibit 4.
Under section 1245, which applies to depreciable personal property such as equipment, furniture and fixtures that is disposed of at a gain, all depreciation taken on the property (including section 179 and bonus depreciation) is subject to recapture. Thus, section 1245 requires “full recapture” of all depreciation taken (straight–line or accelerated) to the extent of the gain.
On the other hand, the recapture provisions of section 1250 apply only to depreciable realty and only to the portion of depreciation taken that represents the excess of accelerated depreciation taken over straight–line depreciation. Because straight–line depreciation has been required for all depreciable realty purchased after 1986, there is no section 1250 recapture on that property, and the gain on its disposal is eligible for long–term capital gain treatment under section 1231. However, to the extent of the depreciation taken, the capital gain, called “unrecaptured section 1250 gain,” will be taxed at the rate of 25% , with the balance treated as section 1231 gain taxed at the regular capital gains rate.
Corporations do not have the unrecaptured section 1250 tax rate but rather an additional section 291 recapture when depreciable realty is sold at a gain. The recapture is equal to 20% of the excess of what the recapture would have been if the property had been subject to the full recapture rules under section 1245, over the partial recapture amount required under section 1250.
The rules of section 1231 and their often complex interaction with other provisions governing capital gains and losses require a great deal of tax planning. For example, generally, the sale by an individual taxpayer or pass–through entity of a section 1231 asset at a gain should be postponed if the individual has a net capital loss in the same year, because of the section 1211(b) $3,000 limitation on the deductibility of net capital losses.
To illustrate, assume that an individual taxpayer in the 35% tax bracket could sell a section 1231 asset at a gain of $80,000, of which $5,000 would be recaptured as ordinary income under section 1245, with the remaining gain eligible for long–term capital gain treatment. The taxpayer also has a capital loss from the disposal of section 1221 assets of $60,000. Were the asset to be sold, the taxpayer would offset the capital loss of $60,000 against the surviving net section 1231 gain of $75,000, resulting in $15,000 of long–term capital gain and $5,000 of recaptured ordinary income, for a total tax liability of $4,000, as shown in Exhibit 5. Had the disposal of the section 1231 asset been delayed to the following year, and assuming no other assets are disposed of, only $3,000 of the capital loss would be currently deductible. Comparing the alternatives, the taxpayer could have saved $600 by delaying the sale. The difference of $600 ($3,000 × 0.20) results from the fact that the $3,000 in Year 1 has a tax savings computed at a 35% ordinary income rate rather than a 15% capital gain rate. Taking into account the time value of money and assuming a discount rate of 6% , the tax savings would be $852, as noted in Exhibit 5.
Similar tax savings result if the $60,000 loss in Exhibit 5 were a section 1231 loss rather than a capital loss. Exhibit 6 demonstrates that it would benefit the taxpayer to postpone the sale of the gain asset and take the ordinary loss deduction of $60,000 in the current year, resulting in a decrease in the current– year tax liability of $21,000. The decision to postpone the section 1231 gain would still be the most advantageous option, even with the lookback rule converting next year’s section 1231 gain to ordinary income.
The above examples illustrate that the timing of asset disposals, the interplay of gains and losses, marginal ordinary income tax rates, and the time value of money work to prevent a one–size–fitsall tax planning solution. Unless a business is under severe duress, it’s often best to plan sales or other disposal of its property to optimize their tax treatment. Whether a straightforward application of section 1231 or some more stepped approach is preferable often depends on factors besides taxes, including the terms of a sale or disposal of property and how the client will adapt to operating without it or wind up its affairs. But CPAs can at least help clients see how tax considerations can figure into their plans to get the best value available when they need to unlock some liquidity from their balance sheets.
Adviser’s Guide to the Tax Consequences of the Purchase and Sale of a Business
For more information or to order or register, visit www.cpa2biz.com or call the Institute at 888–777–7077.
The Tax Adviser is available at a reduced subscription price to members of the Tax Section, which provides tools, technologies and peer interaction to CPAs with tax practices. More than 23,000 CPAs are Tax Section members. The Section keeps members up to date on tax legislative and regulatory developments. Visit the Tax Center at www.aicpa.org/TAX. The current issue of The Tax Adviser is available at www.aicpa.org/pubs/taxadv.
IRC § 1231 allows gains and losses from disposal of property used in a trade or business to be netted and a net gain to be treated as long–term capital gain and a net loss to be treated as an ordinary loss.
Although it is generally in a taxpayer’s interest to recognize gains as capital and losses as ordinary, other tax provisions limit section 1231’s advantages and must be reckoned with by CPA advisers and their clients. These include the five–year “lookback” period for section 1231 net losses that must be recaptured. Any section 1231 gain is ordinary to the extent that it does not exceed any remaining unrecaptured section 1231 losses in the previous five years.
Depreciation recapture provisions of sections 1245 and 1250 can convert into ordinary income all or a portion of gain that would otherwise qualify as long–term capital gain under section 1231. Section 1245 applies to depreciable personal property. Section 1250 applies to depreciable real property and, for property purchased in or before 1986, the difference between accelerated and straight–line depreciation.
Even though capital losses otherwise are limited to $3,000 per year for individuals (and to the extent of capital gains for corporations), it may behoove taxpayers to postpone a section 1231 gain beyond a tax year in which they claim a capital loss. Tax savings can also result from delaying a section 1231 gain beyond a year in which the taxpayer recognizes a section 1231 loss.
Ellen D. Cook, CPA, Dan R. Ward DBA, and Suzanne Pinac Ward, Ph.D., are professors of accounting at the University of Louisiana at Lafayette. Their e–mail addresses, respectively, are firstname.lastname@example.org, email@example.com and firstname.lastname@example.org.