Avoiding ordinary income on the sale or exchange of depreciable property to a corporation.

Under Sec. 1239(a), gains recognized on sales or exchanges between related persons are treated as ordinary income if the buyer will be able to depreciate the property. For this purpose, Sec. 1239(b), (c) and (d) define "related persons" as: (1) a person and a corporation or a partnership, if the person owns (directly or indirectly) more than 50% of the stock's value or more than 50% of the partnership's capital or profits interest; (2) two corporations that are members of a controlled group, as defined in Sec. 267(f); (3) a corporation and a partnership, if the same persons own more than 50% of the stock's value and more than 50% of the partnership's capital or profits interest; (4) two S corporations, or an S corporation and a C corporation, if the same persons own more than 50% of the value of each corporation's stock; (5) a taxpayer and a trust in which the taxpayer (or spouse) is a beneficiary (unless it is a remote contingent beneficial interest); (6) an executor of an estate and a beneficiary of the estate, except for sales or exchanges to satisfy, pecuniary (dollar amount) bequests; or (7) an employer, or a person related to the employer, and a welfare benefit fund controlled by the employer or the related person.

The more-than-50% test is based on the value of the stock owned, rather than on voting control. Constructive ownership rules apply, except that an individual will not be deemed to own the stock of his or her partner, under Sec. 1239(c)(2).

Applying the Rules

These rules apply to property that can be depreciated by the buyer, even if the seller could not depreciate the asset; see Rev. Rul. 60-302. The gain will be ordinary income, even if the purchaser chooses not to depreciate the asset or elects to use an alternative method of expensing (e.g., amortization); see Twentieth Century-Fox Film Corp., 45 TC 137 (1965), aff'd, 372 F2d 281 (2d Cir. 1967) and Kegs. Sec. 1.1239-1(a). If a sale or exchange includes depreciable and non-depreciable property, the gain is allocated between the properties; only the gain allocable to the depreciable property results in ordinary income.

The determination that parties are related is made based on the relationship at a certain time, depending on who sells the property. If a corporation is the seller, the parties are deemed related for Sec. 1239 purposes if they are related either immediately before or after the sale. If an individual sells the property, the determination is made immediately after the transfer, according to Regs. Sec. 1.1239-1(c)(3). Under Regs. Sec. 1.1239-1(c)(4), if the sale is between two controlled entities, the parties must be related both immediately before and after the sale, for Sec. 1239 to apply.

Example

Larry Holman and his son-in-law, Mark Dahl, own 60% and 40%, respectively, of a C corporation that sells contact lenses and glasses. Mark, an optometrist, owns 100% of a separate C corporation in which he practices optometry.

Sales have grown rapidly and both the professional corporation and the retail sales corporation need additional space. Larry and Mark decide to have one corporation purchase Larry's vacation home. The other corporation will purchase the improved property adjacent to that home from an unrelated third party. Larry will recognize a substantial gain on the sale of the vacation home. If the gain is capital gain, Larry can offset it with a capital loss carryforward. The vacation home has never been used as rental or business property.

Larry is not related to Mark's professional corporation. Although Mark's 100% interest is attributed to his wife (Larry's daughter), the 100% interest is not reattributed to Larry from his daughter. However, Larry is related to the retail sales corporation, as he owns more than 50% of it.

Because the vacation home will be depreciable property to either corporation, the gain on the home (excluding the portion allocated to the land) is ordinary income if it is sold to the retail sales corporation (a related person). (The fact that the vacation home was not depreciable property while owned by Larry does not change the ordinary income classification.) In that case, only the gain allocated to the land is capital gain offset by Larry's capital loss carryforward. Only $3,000 of Larry's capital loss carryforward can offset the ordinary portion of the gain.

Larry and the retail sales corporation could allocate more of the sales price to the land to increase the portion of the gain that is capital gain. However, the retail sales corporation may not agree to the allocation, as it would have to forgo depreciation on the amount allocated to the land.

If Mark's professional corporation purchases the vacation home, all of Larry's gain is capital gain, because he is not related to the professional corporation. Larry can then offset all of the gain from the sale of the vacation home with his capital loss carryforward.

Alternatively, Larry could sell the vacation home to Mark, because they are not related parties for Sec. 1239 purposes.

Editor: Albert B. Ellentuck, Esq.

Of Counsel King & Nordlinger, L.L.P. Arlington, VA