Netting Property Transactions at Year-End: Update to the Worksheet Approach for Capital Gain Rate Differentials
By John O. Everett, William A. Duncan, Richard Boley, and Nancy B. Nichols
In the August 1996 CPA Journal, the authors presented a simplified worksheet approach for quickly determining the tax consequences of property transactions entered during the tax year. A five-column worksheet analyzed the effects of additional property transactions before year-end and consolidated all property transactions at the end of the year.
The changes to the individual capital gains netting instituted by the 1997 and 1998 tax acts directly affect this netting process for individuals. These laws established different maximum capital gains rates based on the type of property, and these differential rates also apply to sales of business properties covered by IRC section 1231. The following worksheet supplements the earlier five-column worksheet for property transactions by sorting out the capital gains tax rate implications of transactions involving both business and personal assets.
The Five-Column Worksheet for Property Transactions
The earlier worksheet sequentially netted the results of business and personal property transactions during the tax year. The year-end consolidation of property transactions requires a series of netting procedures for
1) personal property casualty and theft transactions,
2) business- and income-producing property casualty and theft transactions,
3) IRC section 1231 transactions,
4) capital asset transactions, and
5) ordinary income transactions. Under netting procedures 1 through 4, the taxpayer receives the best of both tax worlds (i.e., ordinary loss deductions or long-term capital gains).
Exhibit 1 reproduces this five-column netting procedure, which is explained in further detail in the August 1996 CPA Journal article. Each property transaction that results in a recognized (taxable) gain or loss is entered into one or more of the five columns, and each of the first four columns is then totaled and closed to the appropriate column to the right, depending on whether the columnar result is a net gain or loss. Ultimately, the final effect of all property transactions will be closed to the fifth column, ordinary income. Exhibit 1 indicates the tax forms where the results appear.
The 1997 and 1998 Capital Gains Changes
The primary change in the capital gains tax rules brought about by the 1997 and 1998 tax acts is a reduction in the maximum capital gains rate from 28% to 20%. In addition, a preferential rate applies to taxpayers in the lowest tax bracket (10% capital gains rate when the ordinary income rate is 15%). The 20% and 10% rates are also scheduled to be reduced to 18% and 8%, respectively, for properties held longer than five years.
The former 28% maximum rate continues to apply to “28% gains,” those gains on the sale or exchange of collectibles, such as artwork, held longer than one year, and any gain recognized on the sale of qualifying small business stock held for longer than five years (IRC section 1202). Because only 50% of the latter type of gain is taxable, Congress decided that such gain should not also qualify for the lower 20% rate.
Congress also enacted a new maximum 25% capital gains rate for certain section 1231 gains on the sale of depreciable realty by individuals. Gain subject to the maximum 25% rate is the excess of recapture computed under IRC section 1245 over recapture computed under IRC section 1250 for the realty in question. This difference is referred to in the IRC as “unrecaptured section 1250 gain.”
The revised capital gain and loss netting process, with the varying capital gains rates, can be quite confusing (37 new lines were added to Schedule D to account for the 1997 and 1998 changes). A simple four-column worksheet (Exhibit 2) can be used to determine the final tax rate for a series of net capital gains (which, as mentioned earlier, may include net section 1231 gains). Exhibit 2 contains one column for each possible type of capital gain (short-term capital gain and three categories of long-term capital gain: 28%, 25%, and 20%). Long-term capital loss carryovers are always treated as 28% rate losses (even if the original loss was on a 20%-rate asset), assuring the taxpayer the best use of such carryovers. This is consistent with the netting pattern developed by Congress: When a capital loss is created, it is first used to offset the highest rate category of capital gains, then the next highest rate category.
Once each capital gain or loss is entered into the appropriate column, the netting proceeds are as follows (notations in Exhibit 2 indicate each step described below):
Step 1: 20% rate group netting. If gains and losses in the 20% rate group net to a gain, it is simply taxed at the 20% rate. This rate group includes any net section 1231 gains that would be appropriately taxed at this rate, including all those not subject to the special 25% rate recapture described above. If the gains and losses in the 20% rate group net to a loss, it is first treated as a 28% rate loss and transferred to this column.
Step 2: Short-term capital gain and loss netting. If short-term capital gains and losses net to a gain, it is simply taxed at ordinary income rates. If such transactions net to a loss, it is first treated as a 28% rate loss and transferred to this column.
Step 3: 28% rate group netting. After Step 2, the 28% rate column could include gains and losses on the sale of collectibles or section 1202 stock, long-term capital loss carryover, net loss from the 20% netting, and net short-term capital loss. If gains and losses in the 28% rate group net to a gain, it is simply taxed at the 28% rate. If gains and losses in the 28% rate group net to a loss, it is first treated as an offset against any 25% rate gain and transferred to this column.
Step 4: 25% rate group netting. If the 25% rate group (after transfer of any net 28% rate group loss) nets to a gain, it is taxed at the 25% rate. This rate group includes any net section 1231 gains that would be appropriately taxed at this rate (e.g., sales of depreciable realty at a gain). If the 25% rate group nets to a loss, it then offsets any existing 20% rate gain.
Step 5: 20% rate group netting. If the 20% grouping alone initially netted to a loss (Step 1), Step 5 is unnecessary. However, if the 20% grouping initially netted to a gain, losses in the other rate categories could eventually offset this gain (Step 5). Any gain remaining after this final transfer is simply taxed at the 20% maximum rate.
Finally, if the ultimate result of the five netting steps is a capital loss, then the traditional individual capital loss limitations apply (the 1997 and 1998 tax acts did not change the treatment of capital losses). A maximum of $3,000 of capital losses may offset ordinary income, with any excess losses carried forward indefinitely and retaining their character.
Section 1231 and the Capital Gain and Loss Netting
The section 1231 gain and loss netting process is affected by the differing capital gain rate classifications in two instances, but only if the section 1231 netting produces a net gain (any net section 1231 losses are simply reported as ordinary losses). First, if section 1231 gains exceed section 1231 losses, each such gain or loss must be further classified as either a 20% or 25% rate gain. (Note that 28% rate assets, such as collectibles and section 1202 stock, would not qualify as section 1231 properties used in a trade or business.)
Second, section 1231(c) provides that any current year net section 1231 gain is recharacterized as ordinary income (taxed at rates up to 39.6%) to the extent there are “unrecaptured” net section 1231 losses in the five preceding tax years. In other words, to the extent that a taxpayer has benefited from ordinary net section 1231 loss deductions in the previous five years, an equivalent amount of current-year net section 1231 gains will be taxed as ordinary income.
If a taxpayer is subject to this recapture, which section 1231 rate group (20% or 25%) is recaptured first? While the new law delegates to the Treasury the authority to issue rules in this area, existing Notice 97-59 indicates that the recaptured gain is taken first from the highest rate group (i.e., 25%).
Putting It All Together
The four-column worksheet for sorting capital gain rates may be used as a supplement to the five-column spreadsheet for analyzing property transactions illustrated earlier. The five-column transactions netting process yields a final income number that may include a net long-term capital gain, whose applicable rate can be determined by the four-column worksheet.
Each gain or loss in the section 1231 netting (if a net gain is produced) must be labeled as 20% or 25% gain or loss, and each gain or loss in the long-term capital gains column (if a net gain is produced) must be labeled as 20%, 25%, or 28% gain or loss. Each designated gain or loss is then transferred to the four-column tax rate netting worksheet to determine the final composition of the net capital gain.
A more extensive case study that demonstrates the worksheet in action can be accessed at www.cpaj.com.
Edwin B. Morris, CPA
Rosenberg, Neuwirth & Kuchner
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