Timing Sec. 1231 gains to avoid the "lookback" provisions.

Facts

Tom owns and operates a warehouse that has appreciated in value. Tom's unrealized gain is approximately $22,000. He also has a capital loss carryforward of $26,000.

Tom does not own any other substantially appreciated capital assets. In fact, the warehouse is his only major asset

He plans to sell the warehouse soon and retire. He thinks that he will be able to have on Social Security benefits and interest generated by sales proceeds from the warehouse.

Tom has asked his tax adviser to project his 1992 income tax liability. In gathering the necessary information, the adviser determines that Tom would like to sell the warehouse in 1992 and use the capital loss carryforward to offset his gain. Additionally, the tax adviser notices that Tom reported an ordinary loss of $20,000 from the sale of business assets in 1987.

Issues

Can the anticipated $22,000 gain from Tom's sale of the warehouse be offset by his $26,000 capital loss carryforward?

Analysis

For individual, losses are allowed only to the extent of gains from the sale of capital assets, plus $3,000. Excess capital losses are carried forward indefinitely.

Gains and losses from the sale of certain assets used in the taxpayer's trade or business (that is, Sec. 1231 property) receive special treatment.

Losses from the sale of Sec. 1231 property are treated as ordinary losses to the extent they exceed gains from the sale of Sec. 1231 property; thus, they are not subject to the capital loss limitations. Alternatively, Sec. 1231 gains in excess of Sec. 1231 losses generally are treated as long-term capital gains.

Although net Sec. 1231 gains are generally treated as long-term capital gains, the "lookback" provisions come into effect when the taxpayer has reported net Sec. 19,31 losses in any of the five years immediately preceding the year a Sec. 1231 gain is recognized. in this situation, net Sec. 1231 gains must be recognized as ordinary income to the extent Sec. 1231 losses were reported as ordinary losses in the preceding five years. If Tom sells the warehouse in 1992, the lookback provisions will apply. Because Tom reported net Sec. 1231 losses of $20,000 in 1987, $20,000 of the gain from the sale of the warehouse must be reported as ordinary income. Thus, only $2,000 of the gain will be treated as capital gain, and Tom's use of his capital loss carryforward will be limited to $5,000 (offset against $2,000 of capital gains plus $3,000). This will result in taxable income to Tom of $17,000 ($20,000 of gain + $2,000 capital gain - $5,000 capital loss limit).

Tom will continue to carry forward $21,000 of the capital loss. However, because he does not own any substantially appreciated capital assets, he will be able to use only $3,000 of the loss each year.

The tax adviser informs Tom that if he can postpone the sale until 1993, the lookback provisions will not affect the transaction; the year 1987 would move out of the lookback period and the gain from the sale of the warehouse would be treated as capital gain. None of this gain would be included in taxable income because it would be offset by $22,000 of the capital loss carryforward.

If Tom is unable to postpone the sale until after year-end, he should consider structuring the sale as an installment sale. Recognition of all or a portion of the gain could be deferred until after the lookback period for the 1987 Sec. 1231 loss expires. The gain recognized after 1992 under the installment method would then be outside the lookback period and, as such, would be treated as capital gain (which could be offset by the capital loss carryforward).

Conclusion

Tom will be able to offset only a small portion of the gain from the 1992 sale of the warehouse with his capital loss carryforward. The lookback provisions of Sec. 1231 require that net Sec. 1231 losses were reported as ordinary losses within the five years immediately preceding the year the net Sec. 1231 gains are recognized. Thus $20,000 of the warehouse gain must be reported as ordinary income. The remaining gain of $2,000 will be treated as capital gain and is available for offset against $2,000 of the capital loss carryforward. An additional $3,000 of the capital loss carryforward will be allowed to offset taxable income. If Tom postpones the sale until 1993, the entire Sec. 1231 gain would be treated as capital gain and Tom would be able to use $25,000 of the capital loss carryforward (that is, $22,000 to offset the Sec. 1231 gain plus an additional $3,000).