Tax Ch 12 Business Assets

Question 1

Depreciation recapture carries over to the donee for gifted property.

a,True b. False

Answer 1

a. True

Question 2

Sales of tangible personalty but not involuntary conversions are affected by the carryover of depreciation recapture.

a. True b. False

Answer 2

b. False

Question 3

Depreciation recapture is extinguished upon death.

a. True b. False

Answer 3

a. True

Question 4

Under the 5-year lookback rule, net Section 1231 losses in the current tax year will be subject to ordinary loss rules to the extent of the 1231 gains of the last five years.

a. True b. False

Answer 4

b. False

Question 5

Thirteen months ago, Janae, a 12-year-old middle school student, agreed to take over a paper route to deliver Newsday to her extended neighborhood on a daily basis. To deliver the papers, she purchased a new bike with a specially equipped basket to transport the papers each morning. How is the bike classified for income tax purposes?

a. The bike is an ordinary income asset.
b. The bike is a capital asset.
c. The bike is a Section 1231 asset.
d. The bike is a personal asset.

Answer 5

correct answer is c.

Since the bike is depreciable personal property used in the conduct of trade or business activity and held longer than one year, the bike is considered a Section 1231 asset.

Even though it is used to generate ordinary income, the fact that Janae could claim depreciation on the bike makes it a Section 1231 asset.

Question 6

Custom Framing, Inc., a C corporation, sold a wood cutting machine used in their business for $2,700. They originally purchased the machine for $2,000 and had taken $1,400 in depreciation deductions. When the company that made the machine went out of business, the machine became a collectors item, and the company sold the machine for more than they paid for it to purchase other equipment.
Which of the following statements concerning the tax impact of the sale transaction is correct?

a. The company will recognize $2,100 of ordinary income.
b. The company will recognize $1,400 of ordinary income.
c. The company will recognize a capital gain of $700 that will be taxed at the favorable long-term capital gains tax rate.
d. The company will recognize a short-term capital gain of $700

Answer 6

The correct answer is a.

C corporations do not qualify for the favorable long-term capital gains tax rates, so any gain on the sale or disposition of property is taxed at ordinary rates.

In this case, the adjusted basis of $600 is deducted from the amount realized of $2,700 resulting in a gain of $2,100 which will be taxed at ordinary income tax rates.

Question 7

Ten years ago, Joel purchased an industrial sewing machine used in his business, Danbury Dolls, LLC, for $10,000. He had taken depreciation deductions of $9,000 over this period, and sold the machine for $12,000 after he purchased a new state-of-the-art industrial sewing machine.
How much ordinary income will Joel recognize on the sale of the machine?

a. $0.
b. $1,000.
c. $9,000.
d. $11,000

Answer 7

The correct answer is c.

The sewing machine is a Section 1231 asset.

The amount Joel realized on the sale was $12,000, and after
subtracting his adjusted basis of $1,000 we find his gain to be $11,000.

The sewing machine was personal property, so the recapture rules of Section 1245 apply. Section 1245 requires the gain, to the
extent of depreciation claimed, to be reported as ordinary income on the taxpayer’s return.

The total depreciation that Joel claimed on the asset was $9,000 and his gain was $11,000 so all of the depreciation is recaptured, and will be taxed at ordinary rates.

Question 8

Leanne purchased an apartment building for $2 million several years ago. She has claimed depreciation deductions totaling $950,000 during the holding period, and straight-line depreciation would have been $900,000.
What is Leanne’s long-term capital gain (taxed at the highest regular capital gains tax rate) that will be recognized for income tax purposes if she sells the building for $2.5 million?

a. $0.
b. $50,000.
c. $500,000.
d. $1,450,000.

Answer 8

The correct answer is c.

The apartment building is a Section 1231 asset, which generally means that gains from the sale or disposition of the property are capital gains, and losses are treated as ordinary losses. Before capital
gains tax treatment can be applied, however, depreciation recapture must be taken into account. Since an apartment building is real property, the recapture rules that apply may be found in Section 1250. Section 1250 states that the gain on the sale of real Section 1231 property is taxed at ordinary rates to the extent that the depreciation claimed exceeds straight-line depreciation.

The straight-line depreciation claimed is treated as “unrecaptured Section 1250 gain” and is taxed at a 25% rate. Any gain remaining after the ordinary income recapture and the unrecaptured Section 1250 gain is taxed at long-term capital gains tax rates.

In this case, the gain is $1,450,000 ($2.5 million amount realized less $1,050,000 adjusted basis).

The depreciation in excess of straight-line depreciation is $50,000 ($950,000 - $900,000), which is taxed at ordinary tax rates.

The straight-line depreciation, or unrecaptured Section 1250 gain, of
$900,000 is taxed at a special capital gain rate of 25%,

and the remaining $500,000 of the gain will
qualify as a long-term capital gain

Question 9

After 35 years in business for herself, Freida retired and closed the doors of her office. She gave her desk to her nephew, Desi, who recently completed his degree in a similar field and is opening up his practice. Freida originally paid $12,000 for the desk, and it was fully depreciated by the time she gave it to Desi. Desi used the desk for two years, and then sold it (for $6,000) when he decided to redecorate his office.
How will Desi treat the proceeds from the sale of the gift for income tax purposes?

a. Since Desi received the desk as a gift, there is no need to pay taxes on the proceeds from the sale.
b. Since the desk was given to Desi when it was fully depreciated, it is “loss property,” and the $6,000 proceeds will not be taxable because it fell between Desi’s gain basis and loss basis in the transaction.
c. Desi will recognize $6,000 of ordinary income on the sale.
d. Desi will recognize $6,000 of long-term capital gain on the sale.

Answer 9

Desi will recognize $6,000 of ordinary income on the sale.
The correct answer is c.

When a gift of Section 1231 property is made, the depreciation recapture potential, as well as the taxpayer’s basis, is carried over to the new owner.

Desi received the desk with a basis of zero, and a potential for up to $12,000 of depreciation recapture.

Since Desi sold the desk for $6,000 the entire sales proceeds will constitute depreciation recapture and will be taxed at ordinary income tax rates.

Question 10

Thirteen months ago, Janae, a 12-year-old middle school student, agreed to take over a paper route to deliver Newsday to her extended neighborhood on a daily basis. To deliver the papers, she purchased a new bike with a specially equipped basket to transport the papers each morning.

How is the bike classified for income tax purposes?

The bike is an ordinary income asset.
The bike is a capital asset.
The bike is a Section 1231 asset.
The bike is a personal asset.

Answer 10

The bike is a Section 1231 asset.

Rationale

Since the bike is depreciable personal property used in the conduct of trade or business activity and held longer than one year, the bike is considered a Section 1231 asset. Even though it is used to generate ordinary income, the fact that Janae could claim depreciation on the bike makes it a Section 1231 asset.

Question 11

Chapman owns a building in a blighted downtown area that, until recently, served as his principal residence. He originally purchased the building for $200,000. When he moved out and converted the building to an office building, the fair market value of the building was $150,000.

What is Chapman’s basis for purposes of determining his depreciation deductions on the building?

$0.
$100,000.
$150,000.
$200,000

Answer 11

$150,000.

Rationale

Chapman can claim the lower of his cost basis or the fair market value at the date of conversion as his basis for depreciation purposes.

Question 12

Yael purchased an apartment building for $1.5 million, several years ago. He has claimed depreciation deductions totaling $750,000 during the holding period, and straight-line depreciation would have been $700,000.

How much ordinary income will Yael recognize for income tax purposes if he sells the building for $2 million?

$0.
$50,000.
$1,150,000.
$1,200,000.

Answer 12

$50,000.
Rationale

The apartment building is a Section 1231 asset, which generally means that gains from the sale or disposition of the property are capital gains, and losses are treated as ordinary losses.
Before capital gains tax treatment can be applied, however, depreciation recapture must be taken into account.
Since an apartment building is real property, the recapture rules that apply may be found in Section 1250. Section 1250 states that the gain on the sale of real Section 1231 property is taxed at ordinary rates to the extent that the depreciation claimed exceeds straight-line depreciation.

In this case, the gain is $1,250,000 ($2 million amount realized less $750,00 adjusted basis).

The depreciation in excess of straight-line depreciation is $50,000 ($750,000 - $700,000).

Therefore, $50,000 of the gain will be taxed at ordinary rates pursuant to the depreciation recapture rules of Section 1250.

Question 13

Norma was winding down her business and sold a machine, which she used in the business, to a former business associate, Romano, for $40,000. The machine originally cost $100,000 and Norma’s adjusted basis in the machine was $20,000. The sale agreement requires Romano to pay for the machine in five equal annual installments, plus interest.

Which of the following statements concerning this transaction is correct?

Out of each installment sale payment, the gain on the sale will be treated as ordinary income until all of the depreciation recapture has been accounted for.

Norma may recognize any depreciation recapture over the term of the installment note in the same proportion as recognition of gain.

Norma must recognize all depreciation recapture immediately as ordinary income.

The installment reporting provisions exempt Norma from ordinary income tax treatment of depreciation recapture.

Answer 13

Norma must recognize all depreciation recapture immediately as ordinary income.

Rationale

When an asset subject to depreciation recapture is sold on an installment note basis, the ordinary income depreciation recapture, to the extent of the gain, must be recognized in the year of sale regardless of when the payments on the note are received.

Question 14

Custom Framing, Inc., a C corporation, sold a wood cutting machine used in their business for $2,700. They originally purchased the machine for $2,000 and had taken $1,400 in depreciation deductions. When the company that made the machine went out of business, the machine became a collector’s item, and the company sold the machine for more than they paid for it to purchase other equipment.

Which of the following statements concerning the tax impact of the sale transaction is correct?

The company will recognize $2,100 of ordinary income.

The company will recognize $1,400 of ordinary income.

The company will recognize a capital gain of $700 that will be taxed at the favorable long-term capital gains tax rate.

The company will recognize a short-term capital gain of $700.

Answer 14

The company will recognize $2,100 of ordinary income.
Rationale

C corporations do not qualify for the favorable long-term capital gains tax rates, so any gain on the sale or disposition of property is taxed at ordinary rates. In this case, the adjusted basis of $600 is deducted from the amount realized of $2,700 resulting in a gain of $2,100 which will be taxed at ordinary income tax rates.

Question 15

Twenty years ago, Larry purchased a desk, which he used in his law practice, for $8,000. The desk has been fully depreciated; and when he retired, Larry sold the desk to Sophia for $3,000.

What will Larry include on his tax return as a result of the sale?

$3,000 taxed at ordinary rates.

$3,000 taxed at long-term capital gains rates.

$5,000 ordinary loss.

$5,000 long-term capital loss.

Answer 15

3,000 taxed at ordinary rates.

Rationale

The desk is a Section 1231 asset.

The amount realized of $3,000 less the adjusted basis of $0 equals a gain of $3,000.

Section 1231 gains are usually taxed as long-term capital gains, but before capital gains tax rates can apply the depreciation recapture rules of Section 1245 must be taken into consideration.

Section 1245 requires the taxpayer to recognize the gain to the extent of the depreciation as ordinary income, resulting in a recapture of depreciation claimed over the years.

In this case, the total depreciation claimed was $8,000 and the gain was $3,000.
Since the gain was less than the depreciation taken, the full gain is taxed at ordinary rates due to the imposition of the Section 1245 depreciation recapture rule.

Question 16

During her working years, Lolly ran an antique sales and appraisal service that was very successful in the local community. When she retired, she kept some of the display cases in order to display her own collections in her home. The display cases were originally purchased for the business at a cost of $15,000 and were fully depreciated by the time Lolly retired. Lolly died last month, and the display cases were valued in her estate at $8,000. If Lolly’s daughter, Polly,

inherits the display cases, and sells them for $8,500 two months after Lolly’s death, what is the income tax treatment on the sale?

$500 ordinary income.
$500 long-term capital gain.
$500 short-term capital gain.
$8,000 ordinary income.

Answer 16

500 long-term capital gain.
Rationale

Even though the display cases were Section 1231 assets in Lolly’s hands, and were subject to depreciation recapture, once they ran through Lolly’s estate, they qualified for a Section 1014 step-to fair market value in basis, which eliminates the recapture potential. If Polly sells the cases for $8,500 two months after Lolly’s death, her gain is $500 due to the step-up in basis. Since all assets passing through an estate and receiving a step-up in basis qualify for long-term capital gains treatment, the gain will be characterized as a long-term gain.

Question 17

Earlier this month, Marisol’s apartment house in California was completely destroyed by a forest fire that found its way into the city. She had originally purchased the apartment house for $500,000, and had claimed $100,000 in straight-line depreciation deductions. At the time of the fire, the fair market value of the building was $750,000 and the insurance company gave Marisol a check for the full value. Instead of building on the same site, about six months after the fire, Marisol used the insurance proceeds to purchase a new apartment building for $800,000. Within two weeks of purchasing the new building, a real estate investor offered to purchase the new building from her for $1 million.

If Marisol sells the new building to the investor, what is her long-term capital gain for income tax purposes?

$0.
$200,000.
$450,000.
$550,000.

Answer 17

$450,000.

Rationale

The apartment building is Section 1231 property (real depreciable property used in a trade or business). When a nontaxable exchange occurs, the basis and recapture potential in the original property is carried over to the new property.

Marisol’s basis in the new property is $450,000 (her original cost basis of $500,000 less $100,000 in depreciation plus the $50,000 that she added in addition to the insurance proceeds).

If she sold the building for $1 million, she would have realized a $550,000 gain.

This gain, however, is subject to the depreciation recapture provisions of Section 1250, and un-recaptured Section 1250 depreciation.

There was no accelerated depreciation on the property, so there will be no ordinary income triggered under Section 1250. The straight-line depreciation of $100,000 however will be subject to tax at 25%, leaving the remaining $450,000 gain available for long-term capital gains tax treatment

Question 18

Ten years ago, Joel purchased an industrial sewing machine used in his business, Danbury Dolls, LLC, for $10,000. He had taken depreciation deductions of $9,000 over this period, and sold the machine for $12,000 after he purchased a new state-of-the-art industrial sewing machine.

How much ordinary income will Joel recognize on the sale of the machine?

$0.
$1,000.
$9,000.
$11,000.

Answer 18

$9,000.

Question 19

Cindy, who is in the 32% marginal tax bracket, sold her home this year and is preparing her income tax return. She sold the house for $650,000. It was purchased for $250,000 20 years ago (after she was married to Hayes), and they have used it as their principal residence ever since. Cindy ran a business from the home, using one room regularly and exclusively for business purposes. Over the 20-year holding period, Cindy had claimed $15,000 of depreciation deductions on the home office.

What portion of the gain will be taxed at a capital gain rate of 25%?
$0.
$15,000.
$385,000.
$400,000

Answer 19

$15,000.

Rationale

Even though the home was Cindy and Hayes’s principal residence, and they otherwise meet the qualification rules for the Section 121 exclusion of gain on the sale of a home, Cindy depreciated the property.

Real property that has been depreciated on a straight-line basis is subject to the special long-term capital gains tax rate of a maximum 25% (and is referred to as unrecaptured Section 1250 depreciation).

Therefore, $15,000 will be subject to income tax at a 25% rate (plus 3.8% net investment income tax, if applicable), and the remaining gain will be eligible for the Section 121 exclusion

Question 20

Which of the following statements properly describes the income tax treatment of asset sales?

The sale of classic movies on DVDs by Movie Emporia (a retail movie distributor) will generate income subject to capital gains tax.

The sale of Big Box Mart stock by an individual investor generates ordinary income.

The sale of a desk, which was used for 10 years in a business, at a loss will result in a capital loss.

The sale of a machine used for 10 years in a trade or business at a gain (after recapturing any depreciation) will generate a capital gain.

Answer 20

The sale of a machine used for 10 years in a trade or business at a gain (after recapturing any depreciation) will generate a capital gain

Rationale

A machine used in a trade or business is a Section 1231 asset, and the sale of a Section 1231 asset at a gain is treated as a capital gain.

The sale of DVDs by a retail distributor is a sale of inventory, which generates ordinary income. Big Box Mart stock held by an individual investor is a capital asset, which will generate a capital gain or loss upon sale.

Finally, the sale of a desk used for 10 years in a business at a loss will result in an ordinary loss, since the desk is a Section 1231 asset.

Question 21

Zelda sold a lathe that was used in her business operations (that she ran as a sole proprietor) for $5,000. The machine was originally purchased for $12,500 and Zelda had claimed $6,000 of depreciation deductions over a span of four years.

What will Zelda include on her tax return as a result of the sale?

$1,500 capital loss.
$1,500 ordinary loss.
$7,500 long-term capital loss.
$7,500 ordinary loss.

Answer 21

$1,500 ordinary loss.

Rationale

The lathe is a Section 1231 asset. Losses on Section 1231 assets are treated as ordinary losses for income tax purposes.

Question 22

Prior to returning to work for a Fortune 500 company, Joe ran a consulting practice. He had purchased office furniture and modern artwork for his office; and when he closed the practice to return to the corporate world, he kept the furniture and art, which was fully depreciated. One painting that he used in the business has recently gone up substantially in value. Joe purchased it for $400, depreciated it fully, and the fair market value of the painting is now $10,000. The local art museum has an exhibit dedicated to the artist that created the painting, and since he was not using the art, Joe donated the painting to the museum.

What is Joe’s charitable deduction (without taking into consideration any ceiling imposed by his contribution base) for income tax purposes?

$0.
$400.
$9,600.
$10,000.

Answer 22

$9,600.

Rationale

Joe is generally entitled to a fair market value deduction for contributions of artwork to a charitable organization that will use it in its tax-exempt purpose. The potential depreciation recapture, however, must be subtracted from the fair market value to determine the tax deduction. Since the artwork was fully depreciated, Joe must deduct $400 from the fair market value of $10,000 to arrive at the charitable deduction of $9,600.

Question 23

Which of the following assets held by a manufacturing business is not a § 1231 asset?

Inventory
A machine used in the business and held more than one year
A factory building used in the business and held more than one year
Land used in the business and held more than one year
All of the choices

Answer 23

Solution: The correct answer is A.

Inventory is an ordinary asset.

Question 24

Copper Corporation sold machinery for $27,000 on December 31 of the current year. The machinery was purchased several years ago for $30,000 and had an adjusted basis of $21,000 at the date of the sale. For the current year, what should Copper Corporation report?

A. Ordinary income of $6,000
B. A § 1231 gain of $3,000 and $3,000 of ordinary income
C. A § 1231 gain of $6,000
D. A § 1231 gain of $6,000 and $3,000 of ordinary income
E. None of the choices

Answer 24

Solution: The correct answer is A.

The recognized gain from the disposition of the machinery is $6,000 ($27,000 sale price – $21,000 adjusted basis).

Since the recognized gain is less than the depreciation taken of $9,000 ($30,000 cost – $21,000 adjusted basis) and the asset is depreciable equipment used in a business, § 1245 depreciation recapture applies.

Question 25

Eighteen-year residential real property owned by an individual has accumulated accelerated depreciation of $150,000 at January 1 of the current year. If depreciation had been computed under the straight-line method, accumulated depreciation would be $140,000. The property is sold on January 1 of the current year, with a recognized gain of $175,000. What is the amount of ordinary income depreciation recapture?

A. $10,000
B. $140,000
C. $150,000
D. $175,000
E. None of the choices

Answer 25

Solution: The correct answer is A.

The recapture is calculated under § 1250.

Therefore, only the additional depreciation of $10,000 is recaptured as ordinary income ($150,000 – $140,000).

Question 26

When assets subject to recapture are gifted, which of the following is true?

A. If the donor used the asset in a trade or business and depreciation was allowed, any recapture potential will be retained by the donor.
B. If the asset was personal property, the donee’s gain will be taxed at ordinary income (to the extent of depreciation taken).
C. If the gifted asset was real property, the straight-line depreciation will be taxed at the unrecaptured Section 1231 gains rate.
D. None of the above are true.

Answer 26

the correct answer is B.

If the asset was personal property, the donee’s gain will be taxed at ordinary income (to the extent of depreciation taken).

Question 27

When property subject to depreciation recapture is given to a charitable organization, the potential depreciation recapture is retained by the donor making it a popular tax strategy among business owners.

A. True
B. False

Answer 27

Solution: B - the statement is false.