CPA Prep REG

REG Chapter 10 Part 2: Taxable and Nontaxable Dispositions

Calculate the realized and recognized gain or loss on the disposition of assets for federal income tax purposes

Today’s lesson will be all about taxable and non taxable dispositions of property. This chapter will be an extension of part one of this chapter but we will discuss exactly how these transactions are taxed. Here are today’s learning outcomes:

  • Calculate the realized and recognized gain or loss on the disposition of assets for federal income tax purposes.
  • Calculate the realized gain, recognized gain, and deferred gain on like-kind property exchange transactions for federal income tax purposes.
  • Analyze asset sale and exchange transactions to determine whether they are taxable or non-taxable.

Realized vs. Recognized Gain or Loss

The difference between realized and recognized gain or losses is simple: Realized gains or losses are the gains and losses on paper and the recognized portion of that gain or loss is what impacts your taxes. Just because you realize a gain doesn’t mean its taxable and just because you realize a loss doesn’t mean you can deduct it on your tax return. This is a major distinction that is tested on the exam and you’ll have to be careful before selecting an answer.

Sale of Main Home

Taxpayers may generally exclude up to $250,000 ($500,000 married filing jointly) in capital gains on the sale of their primary residence. Here are the qualifications for this exclusion:

  • Owned the home for 24 months out of the last 5 years.
  • Was your primary residence for 24 months out of the last 5 years.

EXAMPLE 1: John and Susan owned their home and used it as their primary residence for the last 15 years. They purchased the home for $100,000 and made $50,000 worth of improvements over the last 15 years. They sold the home for $400,000 and realized a gain of $250,000 ($400,000 proceeds less $150,000 adjusted basis). They would recognize no gain on the sale of their home because they would use $250,000 of their $500,000 exclusion.

EXAMPLE 2: Bill purchased his home last year and has lived in the home for 12 months. He purchased the home for $100,000 but little did he know his property sat on a major oil supply. An oil and gas company offered him $1,000,000 for the property and he sold the home. He would realize a $900,000 capital gain ($1,000,000 proceeds less $100,000 adjusted cost basis). He will recognize the total gain and wouldn’t be able to exclude any of the gain because he only owned and lived in the home for 12 months.

Installment Sales

An installment sale is a sale of property where you receive at least one payment after the tax year. The installment method allows you to recognize a taxable gain as you receive payment from the sale of the property. If you realize a loss on an installment sale then you have to recognize the total loss in the current tax year.

There are three parts of any installment sale payment:

  • Portion of the adjusted basis (non-taxable/not recognized)
  • Portion of the capital gain (taxable/recognized)
  • Interest (treated as taxable interest income).

The best way to see how this works is by looking at an example.

EXAMPLE 1: Joe sells a lot of land to Jill for $20,000 that will be paid back over the next 4 years. Joe had an adjusted basis of $5,000 in the property so he realizes a $15,000 capital gain ($20,000 – $5,000 = $15,000). 25% of the principal received will go to the original cost basis and the remaining 75% will be recognized as a capital gain ($5,000 is 25% of $20,000 and $15,000 is 75% of $20,000). So if Jill paid Joe $5,000 in year 1 then Joe will recognize $3,750 in capital gains ($5,000 x 75% = $3,750).

Like Kind Exchange

A like-kind exchange is an exchange of one business property for another “like-kind” business property. However, there are some examples of property that are not eligible like-kind exchanges:

  • Stocks & Bonds
  • Inventory
  • Partnership interest
  • Other securities or interest

The best way to deal with like-kind exchange questions is to divide the question into parts:

  • What am I getting?
  • What am I giving?

What you are getting counts towards the proceeds and what you are giving up nets against those proceeds to arrive at the realized gain or loss. Gain is only recognized if there is one.

Let’s look at some examples to break this down.

EXAMPLE 1: Robert wants to exchange one business property for another like-kind business property. His cost basis in his property is $5,000 and the fair market value of the  property he is exchanging for is $6,000. There is a $1,000 realized gain ($6,000 FMV of property receiving less $5,000 adjusted basis in property he is giving up). Since this is a like-kind exchange there is no gain recognized.

EXAMPLE 2: Robert wants to exchange one business property for another like-kind business property. His cost basis in his property is $5,000 and the fair market value of the property he is exchanging is $6,000. In addition, Robert will receive $1,000 cash in the exchange. His realized gain is $2,000 ($6,000 FMV + $1,000 cash received – $5,000 cost basis = $2,000 realized gain). Robert will recognize $1,000 in capital gains because he received “boot” (cash).

EXAMPLE 3: Robert wants to exchange one business property for another like-kind business property. His cost basis in his property is $5,000 and the fair market value of the property he is exchanging is $6,000. Robert has a $1,000 loan outstanding on his property that the other party will takeover payments. His realized gain is $2,000 ($6,000 FMV + $1,000 loan – $5,000 cost basis = $2,000 realized gain). Robert will recognize $1,000 in capital gains because he received “boot” (liability assumed by other part).

EXAMPLE 4: Robert wants to exchange one business property for another like-kind business property. His cost basis in his property is $5,000 and the fair market value of the property he is exchanging is $6,000. Robert will assume a $1,000 loan outstanding on the property he is receiving. His realized gain is $0 ($6,000 FMV – $1,000 loan – $5,000 cost basis = $0 realized gain). Robert will recognize $0 in capital gains because he received “boot” (liability assumed by other part).

The basis in the property received is equal to the fair market value received + deferred loss – deferred gain. The deferred gain/loss is equal to the difference between the realized gain/loss and the recognized gain/loss.

Key Takeaways

  • Know the rules on the sale of a primary residence.
  • Be able to calculate the installment gain in a given year.
  • Be able to calculate the realized and recognized gain in a like-kind exchange.
  • Be able to calculate the basis in like-kind exchange transactions.

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