CPA Prep REG

REG Chapter 10 Part 3: Amount and Character of Gains and Losses

Calculate the amount of capital gains and losses for federal income tax purposes.

Another exciting lesson here for you – today we’ll be discussing the amount and character of gains and losses as it relates to federal income tax. Here are today’s learning outcomes:

  • Calculate the amount of capital gains and losses for federal income tax purposes.
  • Calculate the amount of ordinary income and loss for federal income tax purposes.
  • Review asset transactions to determine the character (capital vs. ordinary) of the gain or loss for federal income tax purposes.

Long Term vs. Short Term Capital Gains/Losses

As discussed in prior parts of this chapter, there are two main distinctions in regards to the holding period of an asset: long-term and short-term. Generally, long-term capital gains/losses occurs when an asset is sold after being held for more than one year (there are exceptions to this rule when it comes to inherited or gifted property which was covered in the last part).

The reason why this distinction is important is because long-term capital gains are taxed at a lower rate while short-term capital gains are taxed as ordinary income.

Screen Shot 2018-01-15 at 8.21.31 PM.png

As shown by this chart, if a taxpayer has a marginal tax rate of 10% or 15% then they would not pay any tax on long-term capital gains. The top tax rate for most taxpayers is 15% and the few who hit the top marginal tax rate will pay the 20% top tax rate. Essentially, short-term capital gains will be taxed at the rates on the left while long-term capital gains will be taxed at the rates on the right.

Netting Process

Taxpayers will typically have a mix of long-term and short-term capital gains and capital losses. There is a netting process to decide if the bottom line will result in a net short-term capital gain/loss or a long-term capital gain/loss.

  1. Short-term gains are netted against short-term losses to arrive at net short-term capital gains/losses.
  2. Long-term gains are netted against long-term losses to arrive at net long-term capital gains/losses.
  3. If the first two steps results in a loss on one step but a gain on the other step then the losses will net against the gains.
    • $10,000 long-term gain – $5,000 long-term loss = $5,000 net long-term gain.  $5,000 short-term loss and no short-term gains. This would net to zero in total.
  4. If the results of step 1 & 2 result in both a short-term loss and a long-term loss (or a short-term gain and a long-term gain) then they retain their character as either short-term or long-term (no netting required).
  5. If there is a short-term loss and a long-term loss then you can only deduct a maximum of $3,000. You always deduct short-term capital losses first and then long-term capital losses second. Any unused losses will be carried forward indefinitely.
  6. Losses that are carried forward retain their character as either short-term or long-term and follow the same netting rules stated above.

Section 1231 Assets

Sale of assets used in a business will be treated differently even if that asset has been held for more than one year. These assets that are primarily used in a business and are held for more than one year are called Section 1231 assets.

Since business owners are allowed to take depreciation on these assets to reduce ordinary income, when they sell the asset they must “recapture” a portion of the gain as ordinary income. The recapture will either be classified as a Section 1245 recapture or a Section 1250 recapture. 1250 is for buildings and 1245 is everything else that isn’t a building (I won’t over complicate the definition so just remember it as building or not building). The calculation seems complicated but it’s pretty straightforward.

EXAMPLE 1: Bob has an asset (not a building) that he used in his business for the last 3 years. He purchased the asset for $10,000 and took $8,000 in depreciation making his adjusted basis in the asset $2,000 ($10,000 original cost less $8,000 depreciation). If he were to sell the asset for $5,000 then he would realize a $3,000 gain. The entire gain will be subject to section 1245 recapture rules and be taxed at ordinary rates.

EXAMPLE 2: Bob has an asset (not a building) that he used in his business for one year and 1 day. He purchased the asset for $10,000 and took $1,000 in depreciation making his adjusted basis in the asset $9,000 ($10,000 original cost less $1,000 depreciation). If he were to sell the asset for $5,000 then he would realize a $4,000 loss. This will be treated as a section 1231 loss not subject to recapture rules.

EXAMPLE 3: Bob has an asset (not a building) that he used in his business for the last 3 years. He purchased the asset for $10,000 and took $5,000 in depreciation making his adjusted basis in the asset $5,000 ($10,000 original cost less $5,000 depreciation). If he were to sell the asset for $20,000 then he would realize a $15,000 gain. $5,000 will be recaptured as section 1245 gain taxed at ordinary rates and the remainder will be taxed as section 1231 gain taxed at lower rates.

So some general rules to make this simple:

  • If it’s a loss it’s automatically a Section 1231 loss.
  • If there is a gain then the maximum recapture is the amount of depreciation already taken.
  • Any excess gain that exceeds the depreciation previously taken will be treated as a Section 1231 gain.

Key Takeaways

  • Long-term gains are taxed at preferred rates.
  • Short-term gains are taxed at ordinary rates.
  • Short-term gains are netted against short-term losses. Long-term gains are netted against long-term losses. Short term gains are then netted against long-term losses or vice versa. If both are a gain or a loss then they keep their status as short-term or long-term.
  • Business assets held for more than one year are Section 1231 assets.
  • Sale of a Business asset that isn’t a building and held for more than one year is a Section 1231 asset and may be subject to Section 1245 recapture rules up to the depreciation previously taken.
  • Sale of a Business asset that isn’t a building and held for more than one year is a Section 1231 asset and may be subject to Section 1250 recapture rules up to the depreciation previously taken.

Jeremias Ramos is a CPA working at a nationally recognized full-service accounting, tax, and consulting firm with offices conveniently located throughout the Northeast. Jeremias specializes in tax and business consulting with focus areas in real estate, professional service providers, medical practitioners, and eCommerce businesses.

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