Best of both worlds? Timing is key in disposing of business property.

EXECUTIVE SUMMARY

* IRC [section] 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.

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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 [section] 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%.

LOOKBACK AND RECAPTURE

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.

TIMING OF GAINS AND LOSSES

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 121 l(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 x 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 ac count 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.

AN ORDERLY DISPOSAL PLAN

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-fits-all 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.

AICPA RESOURCES

Publication

Adviser's Guide to the Tax Consequences of the Purchase and Sale of a Business (#091025)

For more information or to place an order, go to www.cpa2biz.com or call the Institute at 888-777-7077.

The Tax Adviser and Tax Section

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.

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 [e-mail], [e-mail] and [e-mail].

Exhibit 1 Section 1231 Netting Resulting
in Net Gain

Assume that in 2009 an individual taxpayer is the sole shareholder
of an S corporation that disposes of two S 1231 assets:

              $35,000 [section] 1231 gain
              (20,000) [section] 1231 loss
              $15,000 net gain

The net [section] 1231 gain is treated as a long-term capital gain
and pooled with other long-term capital gains and losses. This example,
however, assumes that there are no other capital gains and losses. The
savings from capital rather than ordinary treatment are shown below.

                                                         Taxpayer in
                                                         35% Bracket

Tax at marginal ordinary income rates ($15,000 x 35%)      $5,250
Tax at LTCG rates ($15,000 x 15%)                           2,250
Tax savings in 2009                                        $3,000

Exhibit 2 Section 1231 Netting Resulting
in Net Loss

Assume that in 2009 the S corporation disposes of two [section] 1231
assets:

                    $20,000 [section] 1231 gain
                    (35,000) [section] 1231 loss
                    ($15,000) net loss

The net [section] 1231 loss is treated as an ordinary loss.

                                              Taxpayer in
                                              35% Bracket

Tax savings from ordinary loss treatment at
marginal rates ($15,000 x 35%)                  $5,250

Had the loss been treated as a capital loss, it would have been netted
with other capital gains and losses. If a net capital loss resulted
from that process, only $3,000 of the total loss would have been
allowed as a current deduction for an individual under IRC [section]
1211(b).

Exhibit 3 Net Section 1231 Gain With the
Lookback Rule

Assume that in 2009 the same S corporation disposes of two
[section] 1231 assets as follows:

                      $35,000 [section] 1231 gain
                      (20,000) [section] 1231 loss
                      $15,000 net gain

The company had disposed of a [section] 1231 asset in 2008 at a loss
of $25,000, which was deducted by the owner as an ordinary loss.

Therefore, rather than being netted with other long-term capital gains
and losses, as was the case in Exhibit 1, the entire $15,000 gain is
taxed as ordinary income under the five-year lookback rule.

                                                        Taxpayer in
                                                        35% Bracket

Tax at marginal ordinary income rates ($15,000 x 35%)     $5,250
Tax at LTCG rates ($15,000 x 15%)                          2,250
Loss of tax savings due to lookback rule                  $3,000

Exhibit 4 Exhibit Depreciation Recapture

A business acquired a warehouse in 1988 for $780,000, depreciated
it using straight-line depreciation and sold the asset for $860,000,
when accumulated depreciation totaled $290,000.
A $370,000 [section] 1231 gain was computed as follows:

         Cost                       $780,000
         Accumulated depreciation    290,000
         Adjusted basis              490,000
         Selling price               860,000
         [section] 1231 gain        $370,000

Individual Taxpayer              Corporate Taxpayer

Tentative [section]    370,000   Tentative [section]         $370,000
  1231 gain                        1231 gain
Recapture under              0   Recapture under                    0
  [section] 1250                   [section] 1250
Unrecaptured           209,000   Recapture, if under         $290,000
  [section] 1250                   [section] 1245
  gain taxed at 25%              [section] 291 recapture %       0.20
Remaining [section]     80,000   [section] 291 recapture      $58,000
  1231 gain eligible
  for LTCG rates                 Remaining [section]         $312,000
                                   1231 gain

Exhibit 5 Tax Planning Options: Section 1231
Gain and Section 1221 Capital Loss

An S corporation solely owned by an individual in the 35%
marginal tax bracket wishes to sell a [section] 1231 asset
which, if sold, would result in a gain of $80,000, of which
$5,000 would be recaptured as ordinary income under
[section] 1245. The taxpayer also has a net capital loss for
the year of $60,000.

Option 1: Sell the [section] 1231
asset in the current year

[section] 1231 gain ($80,000-$5,000          $75,000
    recapture)  treated as LTCG
Capital loss                                 (60,000)
Net capital gain                             $15,000
LTCG rate of 15%                              x 0.15
  Tax on gain                                            $2,250

[section] 1245 Recapture amount               $5,000
Recapture taxed as ordinary                   x 0.35
    income at marginal tax rate
  Tax on [section] 1245 recapture                         1,750
Total tax liability in current year                      $4,000

Option 2: Sell the [section] 1231
asset in the next tax year

Current year:

Capital loss, of which only $3,000            $3,000
    is currently deductible
Tax savings at marginal                       x 0.35
    ordinary income rate
Tax savings in current year                             ($1,050)

Next year:

[section] 1231 gain ($80,000-$5,000)         $75,000
Capital loss carryover from previous year    (57,000)
Net gain receiving favorable tax treatment   $18,000
Favorable tax rate                            x 0.15
Tax on [section] 1231 gain                               $2,700

[section] 1245 recapture amount               $5,000
Recapture taxed as ordinary                   x 0.35
    income at marginal tax rate
  Tax on [section] 1245 recapture                         1,750

Total tax next year                                      $4,450

Net tax over two-year period (ignoring                   $3,400
    time value of money) *

Tax savings of Option 2 over Option 1                      $600

* The present value of the $4,450 tax cost in Year 2, using a
discount rate of 6%, is $4,198. Thus, considering the time value
of money, the net tax cost of Option 2 is $3,148 ($4,198 Year 2
tax-$1,050 Year 1 savings). In that case, the tax savings
resulting from postponement would be $852 ($4,000-$3,148).

Exhibit 6 Tax Planning Options: Net Section 1231 Loss

An S corporation solely owned by an individual in the 35%
marginal ordinary income tax bracket wishes to sell a section
1231 asset, which, if sold, would result in a gain of
$80,000, of which $5,000 would be recaptured as ordinary
income under section 1245. The taxpaver also
has a net section 1231 loss of $60,000.

Option 1: Sell the asset
in the current year

[section] 1231 gain ($80,000-            $75,000
    $5,000 recapture)
[section] 1231 loss                      (60,000)
Net [section] 1231 gain                  $15,000
LTCG rate of 15%                          x 0.15
  Tax on net [section] 1231 gain                      $2,250

[section] 1245 Recapture amount           $5,000
Recapture taxed as ordinary               x 0.35
    income at marginal tax rate
  Tax on [section] 1245 recapture                      1,750

Total tax liability in current year                   $4,000

Option 2: Sell the asset in
the next tax year

Current year.

[section] 1231 loss                      $60,000

Treated as ordinary loss resulting in     x 0.35
    tax savings at marginal rate
Tax savings in current year                         ($21,000)

Next year:

[section] 1231 gain ($80,000-$5,000)     $75,000
Less: Amount subject to lookback        ($60,000)
Net [section] 1231 gain                  $15,000
Gain treated as long-term capital         x 0.15
    gain taxed at maximum 15%
  Tax on [section] 1231 gain                          $2,250

Lookback amount                          $60,000
Lookback taxed as ordinary                x 0.35
    income at marginal tax rate
  Tax on lookback                                   ($21,000)

[section] 1245 recapture amount           $5,000
Recapture taxed as ordinary               x 0.35
    income at marginal tax rate
  Tax on [section] 1245 recapture                      1,750
Total tax next year                                  $25,000
6% discount factor                                    0.9434
Present value of the total tax from                  $23,585
  year 2

Net tax over two-year period                          $2,585

Tax savings of Option 2 over Option 1                 $1,415