Understanding the Tax Implications of Selling Business Property

 

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When selling property used in your trade or business, it is crucial to comprehend the tax implications involved. Numerous complex rules can potentially apply. For simplicity, this discussion will focus on the sale of land or depreciable property used in your business, held for more than one year.

Note: Different rules apply to property held primarily for sale to customers in the ordinary course of business, intellectual property, low-income housing, farming or livestock property, and other types of property.

Basic Rules

Under tax law, gains and losses from the sale of business property are netted against each other. The tax treatment is as follows:

1. Net Gain: If net gains exceed net losses, the result is generally subject to long-term capital gain treatment, which is usually more favorable than ordinary income treatment. However, this is subject to the “recapture” rules discussed below.

2. Net Loss: If net losses exceed net gains, the loss is fully deductible against ordinary income. In other words, capital loss deductibility limitations do not apply.

The availability of long-term capital gain treatment for business property net gain is constrained by “recapture” rules. These rules treat amounts as ordinary income rather than capital gain due to previous ordinary loss or deduction treatment.

A special recapture rule applies exclusively to business property. Under this rule, any business property net gain is treated as ordinary income instead of long-term capital gain, to the extent you have incurred a business property net loss within the previous five years.

Different Types of Property

The Internal Revenue Code contains specific provisions for different types of property:

- Section 1245 Property: This includes all depreciable personal property, both tangible and intangible, and certain depreciable real property that performs specific functions. When selling Section 1245 property, you must recapture your gain as ordinary income to the extent of your previous depreciation deductions on the asset.

- Section 1250 Property: Generally, this consists of buildings and their structural components. If you sell Section 1250 property placed in service after 1986, none of the long-term capital gain attributable to depreciation deductions will be subject to depreciation recapture. However, for most noncorporate taxpayers, the gain attributable to depreciation deductions, to the extent it does not exceed business property net gain, will (after applying the business property recapture rule) be taxed at a maximum rate of 28.8% (25% plus the 3.8% net investment income tax) rather than the usual 23.8% rate (20% plus the 3.8% net investment income tax) that generally applies to long-term capital gains.

Additional rules apply to Section 1250 property placed in service before 1987 but after 1980, and to Section 1250 property placed in service before 1981.

Conclusion

As illustrated, even with simplified assumptions, the tax treatment of selling business assets can be complex. For a detailed assessment of the tax implications of specific transactions or for any additional inquiries, please contact us.

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To learn more about transferring your business whether through a sale, generational transition, or change in leadership, join us in-person on October 1, 2024 at 8 AM at the Buffalo Club for a panel discussion on Minimizing Risks & Maximizing Value: Strategies for a Successful Ownership Transfer.