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Fundamentals of Capital Gains: Identifying Section 1231,

1245 and 1250 Gains, 0% Bracket and Form 4797

TUESDAY, JANUARY 21, 2020, 1:00-2:50 pm Eastern

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January 21, 2020

Fundamentals of Capital Gains: Identifying Section 1231, 1245 and 1250 Gains, 0% Bracket and Form 4797

Riley Adams, CPA, Senior Financial Analyst

Google

[email protected]

Michael Plaks, Enrolled Agent

REI Tax Firm

[email protected]

Dawn Polin, CPA, Senior Manager

Cherry Bekaert

[email protected]

Notice

ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY

THE SPEAKERS’ FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY

OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT

MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR

RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.

You (and your employees, representatives, or agents) may disclose to any and all persons,

without limitation, the tax treatment or tax structure, or both, of any transaction

described in the associated materials we provide to you, including, but not limited to,

any tax opinions, memoranda, or other tax analyses contained in those materials.

The information contained herein is of a general nature and based on authorities that are

subject to change. Applicability of the information to specific situations should be

determined through consultation with your tax adviser.

Capital Gain Overview

Purchase Manufacturing Equipment for $10,000

Use it is the business for 2 years

Expense depreciation in the amount of $2,000

Sell in year 3 for $12,000

$12,000 - $8,000 = $4,000 Gain on Sale

Sale of Assets

Sale Price –Purchase Price = Loss or Gain

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Capital

Ordinary

Long Term

Short Term

Considerations for application of tax rates to apply to gain

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Current Tax Rates

Type Ordinary Capital

Individual 37% 20%

C Corp 21% 21%

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Sale of Business Assets

Falls into 3 Categories

▪ §1231 Assets - operating assets of the business

▪ Capital Assets (Investments)

▪ Ordinary Income Assets (assets held for resale such as inventory)

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It ain’t what you know that gets you into trouble. It’s what you know for sure that just ain’t so.

- Mark Twain

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Proprietary + Confidential

0% Capital Gains Tax Rate

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▪ Long-term capital gains tax rates on taxable income: 2019

▪ Modified Adjusted Gross Income (MAGI) above $200,000 (single) and $250,000 (MFJ) is also subject to the 3.8% net investment income tax

▪ With planning, can harvest tax-free gains on invested capital held more than a year or qualified passive income sources

Marginal tax rate Single Married, filing jointly

Head of household

Married, filing separately

0% $0-39,375 $0-78,750 $0-52,750 $0-39,375

15% $39,376-434,550 $78,751-488,850 $52,751-461,700 $39,376-244,425

20% $434,550+ $488,850+ $461,700+ $244,425+

0% Capital Gains Tax Rate

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For 2018-2025, 0% tax rate applies to:

▪ Married tax filers with taxable income up to $78,750

▪ Single filers with taxable income up to $39,375

Most Common Tax Opportunities

▪ Temporarily unemployed/out of labor force

▪ Variable income (e.g., salesperson)

▪ Between ages 55-70 and beginning to transition into retirement / are

already retired

How the 0% Rate Works

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How to Take Advantage:

▪ If you have unrealized long-term gains in assets (e.g., stocks, mutual

funds, etc.) in a taxable account, can sell these investments and

recognize $0 in tax liability <$18,750

▪ Consider exchanging for similar investments to harvest unrealized gain

without tax impact

Item Description

Filing Status Married Filing Jointly

Taxable Income $60,000 (a)

Capital Loss Carryover? No

15% LTCG Threshold $78,750 (b)

Max LTCG with 0% tax $18,750 [(b)-(a)]

0% Capital Gains Examples

Example 1

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▪ Minimal space, but loss carryover provides room to take <$1,750 in

realizable gains with 0% tax impact

Item Description



Capital Loss Carryover? Yes, $3,000 (b)

15% LTCG Threshold $78,750 (c)

Max LTCG with 0% tax $1,750 [(a)-(b)-(c)]

Example 2

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▪ While taxed, still done so at second tier of long-term capital gains tax

rates (15%)

Item Description



LT Capital Gains $40,000 (b)

15% LTCG Threshold $78,750 (c)

LTCG Tax $3,187.50 [(a)+(b)-(c)]*15%

Example 3

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▪ Assets held for longer than 1 year and sold for a gain

▪ Qualified dividends received

Generally considered “qualified” if the company pays a dividend on stock

investor has held more than 60 days during the 121-day period that began

60 days before the ex-dividend date

What Qualifies for LTCG?

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▪ Master limited partnerships (MLPs) - Exists in the form of a publicly traded limited partnership.

Combines the tax benefits of a private partnership—profits are taxed only when investors receive

distributions—with the liquidity of a publicly-traded company.

▪ Real estate investment trusts (REITs) - Company owning and typically operating real estate which

generates income. One benefit of REITs for everyday investors is that they provide the opportunity

to own a portion of real estate which generates dividend-based income. Must return a minimum of

90% of its taxable income in the form of shareholder dividends each year.

▪ Dividends paid on employee stock options - Considered nonqualified dividends, taxed at

marginal rate.

▪ Dividends paid by tax-exempt companies - Considered nonqualified dividends and pay tax at

marginal income tax rate.

▪ Dividends paid on savings or money market accounts - Like any other payment received from

an asset.

What is Not Considered Qualified Passive income?

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The sale of business assets can result in the application of the capital gain rates or the ordinary income rates depending on the facts and circumstances. Sales of 1231 assets slide between the tax rates

Three asset types and two rate categories?

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Distinguishing and calculating 1231, 1245, and 1250 Gain

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1231 Assets Defined

depreciable property used in the taxpayer’s trade or business and held more than one year, other than (i) property includible in inventory, (ii) property held primarily for sale to customers, (iii) intangibles

real property used in the trade or business and held for more than one year, other than property that is includible in inventory or held primarily for sale to customers;

trade or business property held for more than one year and compulsorily or involuntarily converted (¶1748);

capital assets held for more than one year in connection with a trade or business or a transaction entered into for profit, and compulsorily or involuntarily converted;

an unharvested crop on land used in the trade or business and held for more than one year, if the crop and land are sold, exchanged, or involuntarily converted at the same time to the same person;

certain livestock, but not poultry ( ¶1750); and

timber, domestic iron ore, and coal ( ¶1772) ( Code Sec. 1231(b); Reg. §§1.1231-1 and 1.1231-2).

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Gains are treated as capital in nature

Losses are treated as ordinary in nature

Treatment of 1231 Asset Sales

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1231, 1245, 1250?

1231 Gain

1231 Gain Rate

1245 Depreciation Recapture (Ordinary Rate)

1250 Depreciation Recapture (preferential rate)

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§1250 Real Property

Code Sec. 1250 real property, such as a building or

a structural component of a building, and most

land improvements.

Residential rental property that is depreciated over 27.5 years using the straight line

method.

Nonresidential real property that is depreciated over 39 years using the straight line

method.

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Property of Cherry Bekaert LLP

§1245 Personal Property

Code Sec. 1245 personal property (Code Sec. 1245(a)(3)(A)), which consists of items such as business machinery and equipment, office furniture and fixtures,

and appliances that are furnished to tenants. The principal characteristic of Code Sec. 1245 personal property is that

it is readily moveable rather than permanently affixed.

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1231 Gains in Depth

A gain on the sale of the capital asset can be subject to the capital gains rates, and the 1245 and 1250 recapture rates.

To the extent the asset took prior accelerated depreciation expense as a 1245 asset, 1245 recapture will be applicable

To the extent the asset took prior straight-line depreciation expense as a 1250 asset, 1250 recapture will be applicable

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Capital Losses are ordinary in nature. However, net section 1231 losses must be recaptured by treating the current year's net section 1231 gain (section 1231 gain that exceeds current-year section 1231 loss) as ordinary income

What about capital losses?

to the extent of the unrecaptured net section 1231 losses for the five previous tax years ( Code Sec. 1231(c)).

The losses are recaptured on a first-in, first-out (FIFO) basis ( IRS Pub. 544).

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§1231 Gain (Loss) Each Year:

Year 1 = ($10,000)

Year 2 = ($23,000)

Year 3 = $47,000

Example

Looking back 5 years, this taxpayer must treat $33,000 of the gain in year 3 as ordinary. The remaining gain of $14,000 can be treated as capital

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Section 1231 lookback

Why is this an issue?

Because Sec. 1231 offers the best of both worlds:

1. Losses are ordinary and unrestricted by the $3,000 capital loss limitations

2. Gains are capital at preferential rates

Unintended result: clever timing could (if not for the lookback rule) take advantage of both sides.

REI Tax Firm - Michael Plaks, EA www.MichaelPlaks.com

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Example: milking Sec. 1231 if we could

2019: Sold business equipment at a $20k loss

Ordinary loss at 24% bracket: $4,800

2020: Sold business land at a $30k gain

Long-term capital gain at 15%: $4,500

Net result: we’re at $10,000 gain, yet $300 tax drop!


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The 5-year lookback rule:

If you took Sec. 1231 ordinary losses within the last 5 years – put it back!

3-step process:

1. Figure out how much ordinary losses to return

2. Sec. 1231 gains up to that amount will be ordinary gains

3. Whatever is left is capital gains


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Example: Sec. 1231 gains altered by lookback

2019: Sold business equipment at a $20k loss

Ordinary loss at 24% bracket: $4,800

2020: Sold business land at a $30k gain

Ordinary loss recovery - $20k at 24%: $4,800

Long-term capital gain - $10k at 15%: $1,500

Total: $6,300 i.e. $1,800 higher than we wished


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Lookback challenge #1: Tracking

There’re no IRS forms or other mechanisms to keep track of the prior Sec. 1231 ordinary losses.

Intuit tax preparation software – TurboTax and ProSeries – does not track it, either.

Prior 5 years of tax returns are often unavailable or unreliable.

Clients do not want to pay us to do extra work that will end up hurting them.


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Lookback challenge #2: Character of gains

The lookback has consequences beyond merely rate difference:

Carryforward capital losses

NIIT

Suspended Sec. 469 losses (PAL)

Section 199A – QBI deduction

Opportunity Zone Funds


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Proprietary + Confidential

Investment Interest Deduction Election

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What is Investment Interest?

• Interest paid by individuals on a loan where the proceeds were used to

purchase property held for investment.

• Property held for investment includes property which produces

interest, dividends, annuities, or royalties not derived in the ordinary

course of a trade or business

• Interest paid on loans used to buy property held for investment

count as investment interest (e.g., margin loans)

• Can be claimed as an itemized deduction on Schedule A of Form 1040

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What Limitations Apply?

• Deduction for individuals for investment interest expense is limited to net investment income, which is calculated as:

Net Investment Income (NII) = Investment Income - Investment Expenses

• You can determine your NII by subtracting investment expenses not including interest from investment income

• Investment expense deductions can include the following:✓ Accounting fees✓ Legal Fees✓ Fees for automatic investment services (e.g., fees for using a robo-advisor)✓ Fees for investment advice✓ Safe deposit box costs

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Net Investment Income Example

Net Investment Income (NII) = Investment Income - Investment Expenses

1. Subtract all investment expenses not including interest from investment income

• (a) - (b) - (c) = $5,000 - $500 - $250 = $4,250

2. Subtract all investment interest expense up to investment income

• $4,250 - $5,000 = ($750) NII

• Cannot deduct more than investment income, therefore $0 NII with $750

investment interest expense rollover40

What Does NII Not Include?● NII does not include qualified dividends or net capital gains

○ Taxpayer may elect to include these items in NII if advantageous for maximizing

investment interest deduction

● If making this election, taxpayer waives the right to the lower tax rates on LTCG on the

amount included in NII

○ This amount is taxed as ordinary income

● This election to include net capital gains is limited to the lesser of:

○ Net Capital Gains from Investment Property, or

○ Net Gains from Investment Property

● Include amount desired to be considered part of NII on line 4(g) of Form 4952, Investment

Interest Expense Deduction

● Taxpayers can amend previously filed returns to make this election within 6 months of

original due date

● Any unused investment interest expense can be carried forward to future tax years

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Which Trade-Offs Exist for Making this Election?

● Investment expenses still appear as a miscellaneous itemized deduction on

Schedule A of Form 1040 after tax reform

○ Still subject to the 2% floor (can only claim deduction for expenses

exceeding 2% of AGI)

● You must forego the Standard Deduction

○ Can only itemize or claim standard deduction- can’t do both!

○ Itemizing only makes sense if total itemized deductions > standard

deduction

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What About the Medicare Contribution Tax (NII Tax)?

● Modified AGI above $200,000 (single) and $250,000 (MFJ) is also subject to the

3.8% net investment income tax

● When taxpayer has investment interest to be used as an itemized deduction, the

taxpayer should also deduct this when calculating the 3.8% Medicare

Contribution Tax (NII Tax) on unearned income

● Types of unearned income:

○ Pension income

○ Capital gains

○ Interest income

○ Dividends

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Capital gains - Tax planning

1. Timing of sale

2. Capital gains allocations

3. Installment sales

4. Like-kind (Sec. 1031) exchanges

5. Qualified Opportunity Zone Funds


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Timing of sale – A: fluctuating AGI

Everything else being equal (is it ever ?), try to sell in the year with low AGI. Reasons: tax bracket, LTCG, NIIT, AMT

Higher rates of depreciation recapture tax make this consideration more important than 15% LTCG.


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Timing of sale – B: Carry-forward capital losses

Do you have incoming carry-forward capital losses?

If yes, then maybe extra taxes will be absorbed

Do you have assets that need to be sold at a loss?

If yes, then do not wait until the next tax year!


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Timing of sale – C: ordinary v. capital gain netting

Section 1231 recovery (5-yr lookback) and Depreciation recapture on Section 1245 is treated as ordinary income. In contrast, 25% unrecaptured 1250 gain is considered capital gain income.

While the rates and resulting taxes can be the same, only capital gain income can offset capital losses.

Why would that matter?Because of $3,000/yr limit on capital losses


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Timing of sale – D: Passive Activity Losses

Passive activity losses (PAL) could be suspended under Section 469. Two common sources of PAL:

- rental (Schedule E) properties

- K-1s without material participation

Suspended PAL losses from prior years are carried forward, so the client might have a reserve.

Do you have current or carry-forward PALs?If yes – they could be netted against gains!


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Timing of sale – E: unlocked PALs

PALs previously suspended due to high AGI, are released when the property is disposed – regardless of the AGI.

Suddenly, the taxpayer has Sch. E losses, possibly significant, that were not available in the past.

It can wildly swing the overall tax situation. Make sure to consider the impact.


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Land allocation

Purchased $200k house; 25% allocated to land

$50k land; $150k building (27.5-yr asset).

$50k depreciation

Sold for $300k => $150k gain

Standard calculation of tax:

$50k depr. recapture x 25% = $12,500

$100k cap. gain x 15% = $15,000

Total tax: $27,500


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Land allocation

But what if the appreciation of the property is due to the increase in land value, and the current value allocation is 2/3 land ($200k) and 1/3 building ($100k)?

Revised calculation of tax:

$0 gain on the building => $0 depr. recapture $150k cap. gain (land) x 15% = $22,500

Tax savings: $27,500 - $22,500 = $5,000


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Section 1245/1250 allocation

If the property consists of both 1245 and 1250 assets, allocation matters.

Gain on Sec. 1245 property is taxed higher for those above the 24% bracket.

Depreciation recapture on Sec. 1245 property cannot offset capital losses.

It also matters for like-kind exchanges, especially after the tax reform! Only real property can be exchanged!


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Installment sales (aka owner-financing)

You receive down payment + regular payments consisting of principal and interest.

Under Section 453, with installment sale treatment, part of the down payment and each principal payment is considered return of the basis, and part is taxed as gain.

Economic advantages:

- above-market interest rate- often higher sales price- regular income stream- payments are secured (sort of) by the property


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Installment sales (continued)

Tax advantages:

- time value of money, as gains are deferred - usually lowers AGI in each year- unrecaptured 1250 gains are part of the deal!

Risks:- future payments are at risk- foreclosing is a hassle, and property value can drop - may push some gain into a high-AGI future year


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Like-kind (Section 1031) exchanges

Concept: deferring capital gain. Gain is not recognized at the time of disposition and instead is rolled into the replacement property.

Great news: unrecaptured 1250 gain included!

Warning: this is a highly complicated transaction with lots of conditions and traps.

Warning: only real property (Sec. 1250) can be exchanged after the tax reform! Cost segregation complicates 1031 exchanges!


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Qualified Opportunity Zones Funds

Concept: attract capital to develop distressed communities in exchange for tax benefits.

Inception: 2017 Tax Cuts and Jobs Act, aka GOP tax reform

Where? designated zones in all 50 states plus US territories

Zone map and details:www.cdfifund.gov/Pages/Opportunity-Zones.aspx


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https://www.cdfifund.gov/Pages/Opportunity-Zones.aspx



Can be funded with any capital gains, but only gains, not the principal (unlike 1031 exchanges)

180 days after the sale or after the end of the tax year of sale (watch for the small print and traps!)

Restrictions on what is allowed as an investment, including real estate and businesses

Real estate: initial use or “substantial improvement”

A QOZ fund is a self-certified entity, such as an LLC, filing as a partnership or corporation – Form 8996


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Triple tax benefit:

▪ 2010 stock $400k sold in 2019 for $1 Mil

▪ $600k invested in a QOZ fund in Feb. 2020

▪ Grew into a $6 Mil between now and 2046

1. Capital gain tax on the $600k is deferred until 2026 tax return

2. Capital gain on the $60k (10%) is waived (5+ yrs)

3. No taxes on the $600k -> $6 Mil growth !!! (10+ yrs)

Warning: a lot of restrictions and traps – don’t DIY!!!


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Q&A Disclaimer:

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Fundamentals of Capital Gains: Identifying Section 1231 ...media.straffordpub.com/products/fundamentals-of-capital-gains... · Fundamentals of Capital Gains: Identifying Section 1231,