Archive for the ‘recapture’ Tag

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.

Home Office Part I – New Option for 2013

Originally published in the Cedar Street Times

July 26, 2013

In January, the IRS issued Revenue Procedure 2013-13 which discusses a new option for calculating the home office deduction.  (You may want to clip this article and put it in your tax file as a reminder.) Instead of tracking the actual expenses of operating your home office such as water, utilities, garbage, repairs and maintenance, depreciation, etc., you can now elect a safe harbor $5 per square foot of qualified office space, up to 300 square feet ($1,500).  It is kind of like taking a standard mileage deduction on your car instead of tracking gas and repair receipts, and calculating depreciation expense.  Unlike vehicles, however, you can switch methods back and forth from one year to the next.

There are a few interesting provisions that will make it a good option for some people, and a bad option for others.  In other words, when preparing your return you will need to analyze the short and long term impacts, and determine which method is best each year. Since the $5 per square foot figure is not adjusted by region or for inflation, individuals living in high cost states like California are at a disadvantage.

If there is more than one person in the house, such as a spouse or roommate, they can each use the safe harbor as long as they are not counting the same space.  If one person has more than one office in the home for more than one business, the person can either use actual expenses for all the businesses, or the person must use the safe harbor for all the businesses.  However, the maximum deduction allowed is still $1,500 for all the businesses in the home combined, which may have to be allocated pro rata to the businesses based on square footage used by each. If one person has qualified home offices in more than one home, the person can use the safe harbor for one home, but must use actual expenses for the other home.

When claiming the safe harbor deduction, you are allowed to take your property taxes and mortgage interest in full as itemized deductions on Schedule A as well as claiming the safe harbor deduction.  On the surface this sounds like a plus, but for self-employed individuals you are effectively converting expenses that used to be on your Schedule C reducing self-employment taxes to itemized deductions which do not reduce self-employment taxes, and perhaps do not even reduce income taxes if you do not itemize.

Another big difference when claiming the safe harbor deduction is that no depreciation expense is allowed to be taken.  Traditionally, any depreciation expense taken on your home is required to be recaptured at the time you sell your house, and you must pay tax on it.  Even the section 121 exclusion ($250,000 tax-free gain for single/$500,000 for married couples) when living in the house for two out of the last five years will not exempt you from recapture taxes.  Occasionally that can produce negative results, but it is usually helpful because it often helps people avoid income AND self-employment tax which are typically higher than recapture rates.  Nonetheless, I regularly see tax returns where no depreciation was taken on a home office, to “avoid recapture.”  This is incorrect as recapture rules require you to recapture any depreciation “allowed or allowable.”  It does not matter whether you took the deduction or not, you are technically still on the hook for the recapture.

One other notable exception in the 15 pages of new rules explaining the safe harbor is that carryover expenses are not allowed for safe harbor years.  Ordinarily, if your business produces a loss, you are not allowed to create a bigger loss from business use of home expenses with the exception of the portion of mortgage interest, property taxes, or casualty losses which would have been allowed as itemized deductions even if you had no business.  The rest of the expenses get carried over to future years until you make a profit and can use the losses.  Using the safe harbor, any loss generated by the safe harbor disappears forever.  You would be better off in these years using actual expenses in order to preserve the losses for the future.

At the end of the day, you might as well just continue to track the actual expenses, and let your tax professional figure out which method will give you the best benefit each year.

In two weeks, we will go over the basic requirements in order to claim a home office deduction.

Prior articles are republished on my website at www.tlongcpa.com/blog.

IRS Circular 230 Notice: To the extent this article concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law.

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.