Back to Basics Part XIX – Form 4797 – Sales of Business Property

Originally published in the Cedar Street Times

July 24, 2015

Imagine you are reviewing your recently completed personal tax returns in great detail…oh, wait – I am dreaming…imagine that just before fanning all the pages of your returns and stuffing them in a drawer with half used rolls of Scotch tape, a bag of cotton balls, and a few cat toys, your eye happens to land on line 14 on the first page of your tax returns – other income, with a $4,440 figure in it!

You are scratching your head trying to remember getting $4,440 for something. Your cat, perched above, is just staring at you…or maybe judging you.  You take the bait and crack open the return to find the referenced Form 4797.  “Oh, of course, the office equipment I sold!  But wait, I bought it for $15,000 and sold it for $10,200 – isn’t that a loss?  Why do I have $4,440 of income?”

Anyone that has ever had his or her own business or a rental property has almost definitely sold or disposed of an asset related to the activity.  Some do it every few years, and others do it every year.  Perhaps it was a piece of equipment as in our example above, or maybe it was an office desk, a vehicle, or a rental home.  Whatever it was, and every year you did it, you were required to file a Form 4797 – Sales of Business Property – our topic for discussion today.   If you would like to catch up on our Back to Basics series on personal tax returns, prior articles are republished on my website at www.tlongcpa.com/blog .

Although only a two-page form, the Form 4797 can be complicated to tame as it requires an understanding of a lot of concepts and code sections in order to put it to rest.  There are also unique rules that apply to different industries, such as day-traders, farmers, financial institutions, and all of you that are in an industry generating deferred gains from qualifying electric transmission transactions (who has ever even heard of that?!).  Reading much beyond the first page of the instructions will either put you to sleep or leave you with more questions than when you started.

The form itself can require you to be a bit of a “code head.”  Tax accountants that memorize and relate everything to the Internal Revenue Code section numbers sometimes get this label.  The whole second page of the form is a dedication to code heads and is meaningless to the average person.  To fill out this page you have to know what code section the property you are disposing falls under.

Aside from the challenges presented in preparing the form, what most people need to know is that when business assets are disposed they are generally going to wind up on this form.  It is also key to understand the interplay with past depreciation expense claimed.

Getting back to our example, the question remains why you had $4,440 of income related to selling equipment for less than it was purchased?

In this case, a $15,000 piece of equipment was purchased for your business.  Under the normal rules, you are not allowed to take a $15,000 deduction in the year of purchase.  Instead, you depreciate the equipment and spread the expense out over a number of tax years.  You can elect a “straight-line” amount – meaning the same amount each year, but most people stick with the standard accelerated schedules which allow you to take the majority of the expense deduction in the early years.

In this case it would be MACRS 5-Year Property (which actually gets depreciated over six years).  The first year you get to take 20 percent of the purchase price as an expense ($3,000).  In the second year you get to take 32 percent ($4,800).  So after two years you have already depreciated over half the cost – $7,800.  This depreciation expense taken reduces your cost basis in the asset.  So instead of saying your cost was $15,000, your new adjusted cost basis is $7,200 ($15,000-$7,800)

On the first day of the third year you decide to sell it.  Due to depreciation rules you are allowed another $1,440 of depreciation expense for selling it in the third year further reducing your basis to $5,760.  A buyer pays you $10,200.  The sale price less the adjusted cost basis yields a taxable gain of $4,400 ($10,200 – $5,760).  This gain is also taxed at ordinary rates (not lower capital gains rates) since when you took the deductions, you were able to deduct them against ordinary income.  This is called depreciation recapture.

Be glad it was only $4,440 of taxable income.  If you had taken a section 179 deduction to elect to write off the entire amount in the year it was placed in service, your basis would have been zero, and you would have had $10,200 of ordinary income.

If for some reason you were able to sell the equipment for more than you bought it for – say $16,000, you would have had the $4,400 of depreciation recapture at ordinary rates, plus a $1,000 long term capital gain. Tangible property such as this is called Section 1245 property.

The first section of the form generally deals with sales of items that have been held over one year.  The second section generally deals with the sale of assets held less than a year, and the third section generally deals with calculating depreciation recapture for various types of property.  You can also have asset sales that show up in parts one or two, but also in part three.  Part four deals with recapturing depreciation under section 179 and when business use of assets drops below 50 percent.

Travis H. Long, CPA is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.

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