Anytime you dispose of business property, there’s a tax consequence based on the gain or loss from the transaction.
The first step is to calculate the adjusted basis of the property to establish its value. Sometimes basis is equal to the cost of an asset, and sometimes basis is adjusted by improvements, depreciation, and casualty losses. The adjusted basis is used to calculate gain or loss when an asset is disposed. Disposing can include selling, exchanging, retiring, abandoning, converting, or destroying an asset.
The amount realized from the sale or exchange of an asset includes the money received plus the fair market value (defined below) of all property and services you received. It also includes any liabilities assumed by the buyer and any liabilities to which the transferred property was subject (such as real estate taxes or a mortgage).
Fair market value is the price at which property changes hands between a willing buyer and seller when both have reasonable knowledge of the necessary facts and neither is being forced to buy or sell.
For example, let’s say your business owns a building that cost $70,000. You made permanent improvements at a cost of $20,000 and deducted depreciation of $10,000.
Then you sold the building for $100,000 plus property with a fair market value of $20,000. The buyer assumed your real estate taxes of $3,000 and a mortgage of $17,000. You also incurred selling expenses of $4,000. Here’s the calculation of the taxable gain on this sale:
|FMV additional property||20,000|
|Real estate taxes assumed by buyer||3.000|
|Mortgage assumed by buyer||17,000|
|Less selling expenses||(4,000)|
|Net amount realized from sale||$136,000|
|Cost of building||$70,000|
|Gain on sale||$56,000|
Generally, if you’ve held an asset more than 12 months, the proceeds from the sale are treated as long term capital gains, resulting in a more favorable tax rate. If you’ve held the asset for fewer than 12 months, the proceeds are taxed as ordinary income, with a higher income tax rate.
All the gains and losses on sales of your business property throughout the year are netted against each other, resulting in a net gain or loss. If the outcome is a net gain, then you can utilize long term capital gain tax treatment, subject to recapture rules explained below. If the end result is a net loss, the loss can be deducted against ordinary income.
And this is where recapture rules come in. Recapture rules govern when a gain can be treated as a long term capital gain or must be considered ordinary income due to an earlier ordinary loss or deduction. If your business had a business property net loss within the last five years, any business property net gain will be considered ordinary income rather than long term capital gain.
Throughout the life of an asset, a business can take depreciation deductions and receive favorable tax treatment. When that asset is sold, Section 1245 of the Internal Revenue Code recaptures depreciation and taxes the gain at ordinary income tax rates. Section 1245 property generally includes personal property and other tangible property except buildings and their structural components . . . which are considered Section 1250 property.
When Section 1250 property (such as commercial buildings) is sold at a gain, the IRS taxes that gain as ordinary income if the accumulated depreciation exceeds straight line depreciation. This especially applies when real estate is depreciated using accelerated depreciation, resulting in higher deductions in the earlier years compared to straight line depreciation calculations.
These rules can be complicated! For more information, refer to IRS Publication 544, Sales and Other Dispositions of Assets, and feel free to contact us for assistance with your business situation.