Know the Tax Impact When Disposing of Capital Assets
When you sell, scrap, or otherwise remove a capital asset from your business, you'll have to report the change to the IRS. The good news is that long-term capital gains are taxed at a lower rate than other income, and if you have a loss on the property, you can deduct it. The bad news is that you may have ordinary income as a result of expensing or depreciation. And, you may find yourself subject to the 3.8 percent tax on Net Investment Income.
When you dispose of a capital asset, you must report the disposition to the IRS. The amount of tax that you will owe depends on a number of factors. Among these factors are the following:
- Whether you had a gain or a loss on the sale
- How long you owned the asset
- The type of asset (Special rates apply to particular types of assets.)
- Your income (Higher income taxpayers face higher capital gain tax rates.)
- Your taxable income (This may also trigger liability for the new 3.8 percent net investment income (NII) Medicare tax.)
- Whether depreciation recapture is required
- Whether you receive the payments in one year or spread over a number of years
This article, and its two companion articles ("Net Investment Tax Hits Higher Income Taxpayers" and "How to Compute Capital Gains/Losses"), address tax issues that you will face when you dispose of capital assets.
The like-kind exchange rules may help you avoid tax liability when you dispose of business property. In some cases, if you trade business property for other business property of the same asset class, you do not need to recognize a taxable gain or loss.
Instead, you'll be treated as making a nontaxable like-kind exchange, in which the tax basis of the old property becomes the tax basis of the new property.
Consult your tax adviser for more details if you think you may want to arrange a like-kind exchange, since there are some very complicated rules to follow.
Is Gain Long-Term or Short-Term?
Property that is held for one year or less is considered to be held on a short-term basis. Any short term gain that is not offset by losses or long-term capital gain is taxed at ordinary income tax rates.
Property held for more than one year is considered "long-term" property. This gain (after all gains and losses are netted together) will generally be treated at the far more favorable long-term capital gains.
Capital Gains Rates Are More Favorable
For most people and most types of property the long-term capital gains rate is 15 percent. However, different rates apply to both lower-income and higher-income taxpayers, based up the marginal tax rates. In addition, certain types of property are taxed at a different rate.
Lower-income taxpayers. If you are in the 10-percent or 15-percent tax bracket, then your capital gains tax rate is zero percent.
Higher-income taxpayers. If you are in the 39.6 percent tax bracket, your capital gains tax rate will be 20 percent, beginning in 2013.
For 2013, the 39.6 percent rate applies to unmarried taxpayers with taxable income over $400,000; married taxpayers who file jointly with income over $450,000; and heads of household filers with incomes over $425,000. These amounts are indexed for inflation beginning in 2014. In 2014, the 39.6 percent rate starts at $406,750 for unmarried taxpayers and $456,600 for joint return filers.
Collectibles, such as stamps, antiques, gems, and most coins, are taxed at 28 percent, regardless of how long they are held and the taxpayer's tax bracket.
Qualified dividends (those received from most domestic corporations and certain foreign corporations) are taxed at capital gains rates, rather than at ordinary income rates.
This lower taxation rate for qualified dividends provides a strong incentive to operate your business as a corporation. Compensation received from a corporation can be divided between salary and dividends. This means the dividend portion will likely be taxed at the capital gains rate, which is inevitably lower than your ordinary income tax rate.
What's more, you will not owe self-employment tax on the dividend portion of the payments. And, if you are actively involved in your business, these dividends are not included in determining liability for the new 3.8 percent net investment Medicare tax.
Qualified Small Business Stock Provides Outstanding Tax Savings
If you hold, or purchase, qualified small business stock, you may be able to exclude a significant portion (if not all) of any capital gain from your income. There is a special tax break designed to help qualifying small C corporations raise capital by allowing long-term, non-corporate investors in original issue stock to cut the tax on their profit.
In order to take advantage of the exclusion, an individual must hold the qualified business stock for at least five years. The amount that can be excluded depends upon the date on which the stock was acquired.
|Date Stock Acquired ||Percent of Gain |
Excluded from Income
|Tax Rate on Gain Not |
Excluded from Income
|After 12/31/2013 ||50% ||28% |
|After 9/27/2010 but before 1/1/2014 ||100% ||N/A |
|After 2/17/2009 but before 9/28/2010 ||75% ||28% |
|After 8/10/1993 but before 2/18/2009 ||50% ||varied |
The exclusion applies only to gain on eligible stock (1) originally issued by a qualifying corporation after August 10, 1993, and (2) held for more than five years.
Other rules are as follows:
- The stock must be acquired in an exchange for money or other property (other than stock), or as compensation for services provided to the corporation (other than acting as the stock's underwriter).
- The small business must be a regular C corporation; it must have $50 million or less in aggregate capital as of the date of stock issuance; and at least 80 percent by value of corporate assets must be used in the active conduct of one or more trades or businesses.
- The corporation cannot be involved in the performance of personal services (such as health or law) or in the finance, banking, leasing, real estate, farming, mineral extraction, or hospitality industries. A number of other types of businesses, such as mutual funds and REITs, are also disqualified.
Limit on exclusion amount. The exclusion for each eligible corporation applies only to the extent that the gain does not exceed the greater of
- 10 times the taxpayer's adjusted basis in the stock disposed of during the tax year (post-issuance additions to basis are disregarded), or
- $10 million ($5 million for marrieds filing separately), reduced by gain excluded in earlier years from sales of stock in the corporation.
Stock acquired by gift and via rollovers. Although a post-issuance purchaser of otherwise qualified stock doesn't get the exclusion, the tax break is preserved for those who receive such stock as a gift or due to the death of the original purchaser. The transferor's holding period also carries over to the transferee. Similar rules apply to qualified stock distributed by a partnership to its partners.
Recaptured Depreciation Is Ordinary Income
When you dispose of a capital asset, the amount of depreciation allowable for that asset will be taxed at your ordinary income rates, not the capital gains rate. This means that if you realize a capital gain on the sale or other disposition of property used in your trade or business, you probably won't get the benefit of the special capital gains tax rate on the entire amount of your gain.
The tax rules for recapture differ, depending on whether the property is real property or personal property. In addition, there is a special, more generous rule for home offices.
Recapture rules for personal property, other than cars. If you have a capital gain on any depreciable personal property, you must report all or part of the gain as ordinary income to reflect the amount of depreciation allowable, as well as any first-year expensing deductions that you claimed on the asset.
The amount that must be reported as ordinary income ("recaptured") is equal to the lesser of:
- the total of depreciation and expensing deductions allowable on the asset, or
- the total gain realized
If the total gain realized is more than the amount that must be recaptured and you held the asset for more than one year, the excess will be taxed at the long-term capital gain rate. However, if the total of the depreciation deductions is greater than the gain realized, the entire amount of the gain is reported as ordinary income.
Recapture rules for real estate. The recapture rules apply to real estate as well as personal property. So, if you realize a capital gain when you dispose of real estate, you must report all or part of the gain as "recaptured" income to reflect the amount of depreciation, claimed on the asset.
The amount that must be recaptured is equal to the lesser of:
- the total depreciation allowable on the asset (except that for home offices, only depreciation for periods after May 6, 1997 counts), or
- the total gain realized
If the total gain realized is more than the amount that must be recaptured, the excess may be reported as a capital gain (with its lower rate) provided that the asset has been held for more than one year. If the total of the depreciation deductions is greater than the gain realized, the entire amount of the gain is taxed at 25 percent rate.
Plan Ahead to Minimize Depreciation Recapture
Advance planning may help you reduce the amount that must be recaptured when you dispose of a business asset or minimize the impact of recapture on your tax situation.
If you choose to depreciate a property quickly, the property's adjusted basis will be reduced more quickly than if you had depreciated the property more slowly, and you will have more taxable gain on the sale of the asset. Moreover, as a general rule, the faster you depreciate property, the more likely it is that you will have a recapture liability when you sell the property, and the more likely that this liability would be larger than if you have chosen slower depreciation. thus, if you know that you will not hold the property for long, then you should consult a tax professional on how to optimize depreciation.
All things being equal, it's best to be hit with a recapture in a year in which your business has an operating loss (which can be used to offset the recapture amount), rather than in a profit year, when the recapture liability will increase your taxable income, and possibly even move you into a higher tax bracket.
Strategies aimed at the timing or minimization of depreciation recaptures may be worthwhile, but don't fall in the trap of over-focusing on tax issues. First, consider the business consequences when deciding whether and when you should sell an asset. Tax considerations should run a distant second when making these kinds of decisions.
Installment Sale Treatment May Lower Taxes
If the sale qualifies, reporting your gain using the installment method may enable you to lower your overall tax bill. The installment method can be used to defer some tax on capital gains, provided:
- you receive at least one payment for a piece of property after the year of the sale and
- the property qualifies for installment treatment.
What Assets Are Eligible for Installment Treatment
You can elect installment sale treatment only for gains you have on assets that have appreciated in value beyond their original purchase price. For older businesses, gain on intangible assets such as business goodwill will also be eligible for installment sale treatment, because under the law prior to 1993, goodwill could not be depreciated or amortized (hence, there's no depreciation to be recaptured.)
Gains that must be treated as ordinary income will not be eligible for installment sale treatment. Examples includes payment for your inventory, for accounts receivable, and for property that's been used for one year or less. This also includes payments for any personal property or real estate to the extent of any depreciation that must be recaptured, based on deductions you've claimed over the years.
Using the Installment Method
To use the installment method, you must do the following:
- Allocate the total purchase price you received among all the assets you've sold in the transaction.
- Compute your "gross profit percentage," which is your gross profit (your selling price minus: the tax basis of the property, selling expenses, and any depreciation recapture) divided by the selling price of the asset.
Each time you receive a payment from the purchaser, the principal portion of the payment (i.e., everything but the interest) is multiplied by the gross profit percentage to determine the amount that must be reported as taxable gain for the year.
Form 6252 Is Used to Report Installment Sales
Installment sales are reported on IRS Form 6252, Installment Sale Income. A separate form should be filed for each asset you sell using this method. You must file this form in the year the sale occurs, and in every later year in which you receive a payment.
Among the Business Tools are Form 1040 and Form 6252. They are in Adobe Portable Document Format (.pdf), and you will need the free Acrobat Reader to view and print the file.
Special Rules Apply To Assumed Debt or Additional Payments
If the buyer assumes any of your debt as part of the installment deal, the assumption is treated as a payment to you for purposes of the installment sale rules. If the buyer places some of the purchase price in an escrow account, it's not considered a payment until the funds are released to you, as long as there are some substantial restrictions on your ability to get the money.
If your deal includes a provision under which you may be entitled to additional payments based on future performance of the business, more special rules apply. Please see your tax adviser for details.
Installment Sale Case Study
On January 1, you sold some commercial real estate. The total price was $600,000: $500,000 was allocated to the building and $100,000 was for the land underneath. Your selling expenses were $37,500. You originally purchased the property 10 years ago for $300,000 ($250,000 for the building and $50,000 for the land). Over the years you've claimed $61,168 in depreciation using the straight-line method. For simplicity, we'll assume you're a cheapskate and made no capital improvements to the building during the time you owned it.
The buyers made a $200,000 down payment and will pay the rest off at 10 percent interest on a 20-year amortization schedule, except that at five years the unpaid principal will be due in a balloon payment.
First, it is necessary to separate the transaction into two portions: the building, and the land:
| ||Building || ||Land |
|Cost basis: ||$ 250,000 || ||$ 50,000 |
|Less: depreciation ||- $ 61,168 |
| ||- $ 0 |
| ||$ 188,832 || ||$ 50,000 |
|Plus: expenses of sale ||+ $ 31,250 |
| ||+ $ 6,250 |
|Adjusted basis: ||$ 220,082 || ||$ 56,250 |
"Building only" portion of the transaction. Once you have separated the building portion from the land, you need to determine your net gains on the sale of the building alone. This will be the sales price minus the adjusted basis computed above, or $500,000 - $220,082 = $279,918. Since this amount is greater than the $61,168 in depreciation, all of the depreciation you claimed over the years would be "recaptured" and taxed in the year of the sale.
The remainder of your profit on the building, or $218,750 (since $279,918 - $61,168 = $218,750) would be divided by the selling price of $500,000 to arrive at your gross profit percentage for the building: $218,750/$500,000 = .4375, or 43.75 percent.
Land portion of the transaction. For the land, no depreciation was allowed, so there is no recapture. Your profit on the land is the price less the adjusted basis, or $100,000 - $56,250 = $43,750. Your gross profit percentage of the land would be $43,750/100,000 = .4375, or 43.75 percent.
Allocation for principal and interest. For every payment you receive, including the down payment and the balloon, separate the principal from any interest (all interest is taxed as ordinary income).
Of the principal, 1/6 will represent a payment for the land, and 5/6 will represent a payment for the building. Of the payment for the land, 43.75 percent will be taxed as capital gains, and the remainder is a return of your capital which is not taxed. Of the payment for the land, 43.75 percent of each payment will be taxed as capital gains, and the rest represents either the recaptured depreciation, which was taxed in the year of the sale, or the return of your capital which is not taxed.
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