Question

Mona Inc. makes and distributes bicycle accessories. To streamline its operations and to become leaner, it had the following transactions: It sold a machine that made some accessories for $54,600 cash. The machine originally cost $38,400 three years ago and has accumulated depreciation of $16,000. Mona Inc., owned stock of XYZ Corporation worth $24,000 at the beginning of the year and $30,460 at the end of the year. Mona sold some inventory for $14,000 with a cost of $10,000 during the year. Mona disposed of an office building with a fair market value of $150,000 for another office building of $110,000 and received $40,000 in cash. The sold building was purchased seven years ago for $124,000 and has been depreciated for $30,000. Land held for investment was sold for $56,000 with an original basis of $64,000 and no depreciation. Mona Inc. sold another machine on account in four installments notes of $24,000; the first payment was received in 2018. It purchased the machine two years earlier for $64,000 and has claimed $18,000 in depreciation on the machine. Stock originally purchased eight years ago for $4,200, was sold in 2018 for $5,500. Mona Inc. sold another machine for $14,600. The machine was purchased six months earlier for $18,000 and at the date of the sale had accumulated depreciation of $1,660. Requirements: Explain the character of gain/loss realized and recognized for each of the events in the 2018 tax year. Define Section 1231 of the Internal Revenue Code (IRC), capital gain/loss, and ordinary gain/loss. Classify each event as section1231, capital gain/loss, or ordinary income. Use provisions of the most recent tax law. From the determination made in part A, determine the net Section 1231 gain/loss and the net ordinary gain/loss to be included in its tax return. Note that Mona Inc. had a $4,000 non-recaptured net Section 1231 net losses from previous years. Using ProConnect or fillable forms, complete Mona Inc.’s Form 4797. Use the most recent and most current form available. Convert it to a Word document from a PDF or embed your PDF into Word.

Answer 1

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Transaction 1 Section 1231 asset (with Section 1245 recapture component); total gain of $32,200, with $16,000 being a Section 1245 gain and $16,200 being a Section 1231 gain; reported in Part III of Form 4797

Transaction 2 No gain or loss

Transaction 3 Ordinary income of $4,000; not Form 4797 reportable

Transaction 4 Section 1231 asset, with portion of gain deferred under like-kind exchange rules; total gain of $40,000, with $30,000 being characterized as an unrecaptured Section 1250 gain; reported in Part I line 5 of Form 4797

Transaction 5 Capital loss of ($8,000)

Transaction 6 Section 1231 asset (with Section 1245 recapture component); total gain of $26,000 recognized in 2018, with $18,000 being ordinary under Section 1245 and $8,000 being a Section 1231 gain; note that $24,000 of gain is deferred to future tax years

Transaction 7 Long-term capital gain of $1,300

Transaction 8 Ordinary loss of ($1,740)

Total ordinary gain: $36,260 (Note that this excludes the $4,000 inventory income; inventory revenue and costs are supposed to be reported as gross receipts and cost of goods sold, not as a gain/loss transaction)

Total Section 1231 gain: $60,200

Net capital loss before limitations: ($6,700)

Explanation:

Before looking at individual transactions, it's helpful to go ahead and explain the types of gains/losses, as requested by the problem.

Broadly speaking, gains and losses can fall into one of three kinds: ordinary, capital, and Section 1231. Ordinary gains and losses typically arise in the context of disposals of true "ordinary assets" (such as receivables) or disposals of trade or business assets that were held for 1 year or less and that would otherwise qualify for Section 1231 treatment. Capital gains and losses relate to disposals of "capital assets", as defined in Section 1221. Broadly speaking, capital assets are generally thought of as things like stocks, bonds, or assets held as an investment. In actuality, capital assets include essentially any asset other than those that qualify as a true "ordinary asset" or as a Section 1231 asset. Finally, a Section 1231 asset is generally the disposal of an asset held for more than one year and used in a trade or business, subject to special rules for recapture and "look back" that will re-characterize a portion of gains as "ordinary". These classifications matter because of income characterization rules. Ordinary gains and losses are includible in or deductible against ordinary income, and in the case of gains, they are subject to the individual's regular marginal tax bracket. Capital losses face deduction limits against ordinary income ($3,000 per year for individuals, $0 for corporations). Capital gains are subject to either normal marginal tax bracket rates (for short-term capital gains) or special long-term capital gains rates (for long-term capital gains). Section 1231 gains and losses get the best of both worlds: losses are treated as ordinary losses and deductible against ordinary income; gains (except to the extent of repapture or re-characterization) are treated as long-term capital gains and use the special long-term capital gains rates. As noted, two special rules come into play for Section 1231. For machinery and equipment, any gains that would otherwise qualify under Section 1231 are subject to re-characterization as ordinary gains in an amount equal to the lesser of the actual gain or the accumulated depreciation. Also, when a business incurs a net Section 1231 loss, then for the next 5 years (look-back rule), any gains that would otherwise be Section 1231 gains are re-characterized as ordinary gains. It's also worth noting that, under Section 1250, disposals of buildings follow a similar rule to Section 1245 except that the lesser of the gain or accumulated depreciation is treated as an "unrecaptured 1250" gain. For individual taxpayers, unrecaptured 1250 gains are subject to a special maximum 25% tax rate.

With this in mind, we can analyze each type of gain/loss transaction (if any).

Transaction 1 This asset was held for more than one year and was used in a trade or business. Therefore, it will generally be a Section 1231 asset, subject to potential recapture rules. The net tax value at the time of the disposal is $22,400 ($38,400 cost less $16,000 accumulated depreciation). The net gain is $32,200 ($54,600 proceeds minus net tax value $22,400). Since this is a gain on disposal of a machinery or equipment asset with accumulated depreciation, the next step is to compute the Section 1245 recapture. This is the lesser of the gain ($32,200) or depreciation ($16,000). In this case, the Section 1245 recapture is $16,000; and the remaining $16,200 gain retains its character as a Section 1231 gain.

Transaction 2 There is no gain/loss transaction present. A mere change in the value of an asset is generally not a taxable event. While an exception does exist for a "mark to market" election, it is available only to taxpayer's whose business is trading securities. This is not Mona's primary business.

Transaction 3 The sale of inventory results in $4,000 ($14,000 sale price minus $10,000 cost) of ordinary income. Note that sales of inventory are not reportable on Form 4797.

Transaction 4 The office building is subject to a special rule for like-kind exchanges of real property. Generally, such exchanges are treated under Section 1031 and are not taxable. However, to the extent of the lesser of the gain or "boot" (i.e., not like-kind property) received, that portion is taxable. In this case, the amount realized is $150,000 ($110,000 for the like-kind building received; $40,000 in cash). The adjusted basis of the property given up is $94,000 ($124,000 cost minus $30,000 accumulated depreciation). The grand total "realized" gain is $56,000 ($150,000 minus $94,000). The recognized gain is equal to the lesser of the realized gain of $56,000 or the $40,000 cash "boot" received. In this case, the recognized gain is $40,000. This is a $40,000 Section 1231 gain (of which $30,000 would be an unrecaptured Section 1250 gain)

Transaction 5 Since this land was held for investment, it is treated as a capital asset. The ($8,000) loss ($56,000 proceeds minus $64,000 cost) is treated as a capital loss.

Transaction 6 This transaction requires two special rules: ordinary income recapture and an installment method sale. Broadly speaking, income from the sale of assets under the installment method is computed by first calculating the grand total expected gain on the sale of the asset, and then recognizing that gain proportionally each year as payments are received. However, to the extent of Section 1245 recapture, this portion of the gain must be recognized in the current year, even if no payments are received in the first year. The adjusted basis is $46,000 ($64,000 cost minus $18,000 accumulated depreciation). The total expected proceeds are $96,000 ($24,000 times 4 installments). The total gain is $50,000. Of this, the lesser of the $50,000 gain or $18,000 depreciation is subject to Section 1245 recapture. In this case, the recapture is $18,000, which is immediately includible in income. The remaining $32,000 gain is subject to the installment method rules. For this step, it is helpful to fill out Form 6252. But simply speaking, $8,000 of this gain is recognized in 2018. The Form 6252 computes this based on the installment gain gross profit percentage of 33.3% ($32,000 installment gain divided by $96,000 total proceeds), times the 2018 payments of $24,000, resulting in $8,000 installment gain recognized in 2018. This installment gain retains its Section 1231 character.

Transaction 7 This is a simple long-term capital gain of $1,300 ($5,500 minus $4,200).

Transaction 8 This will be an ordinary gain/loss asset because it was held for 1 year or less before disposal. The ordinary loss is ($1,740), equal to the $14,600 proceeds minus the $16,340 net tax value ($18,000 cost basis minus $1,660 accumulated depreciation). No test for Section 1245 recapture is required because (1) it's a short-term asset, and (2) the net result is a loss.

For answering the total gain and loss, it's helpful to go ahead and complete Form 4797 in order to accurately account for the various components. Note that, to more easily facilitate reporting of the Sec 1245 recapture portion of the installment sale asset, my solution includes only the $18,000 Section 1245 gain as the proceeds, cost, and accumulated depreciation on the Form 4797.

The $36,260 ordinary gain is equal to the $16,000 Section 1245 recapture in Transaction 1 + the $18,000 Section 1245 recapture in Transaction 6 + the ($1,740) ordinary loss in Transaction 8 + the $4,000 re-characterized look-back unrecaptured Section 1231 losses. Note that I am excluding the $4,000 net income from the sale of inventory. Per the Form 4797 instructions, sales of inventory are not supposed to be included. Instead, revenues and costs related to inventory are reported as gross receipts and cost of goods sold.

The $60,200 Section 1231 gain is equal to the $16,200 Section 1231 gain in Transaction 1 + the $40,000 Section 1231 gain in Transaction 4 + the $8,000 Section 1231 gain in Transaction 6 (installment method) + the ($4,000) re-characterized look-back unrecaptured Section 1231 losses.

The ($6,700) capital loss is equal to the ($8,000) capital loss in Transaction 5 + the $1,300 gain in Transaction 7.

4797 Sales of Business Property OMB No. 1545-0184 Form (Also involuntary Conversions and Recapture Amounts Under Sections 179 and 280F(b)(2)) 2019 Department of the Treasury Attach to your tax return. Attachment Internal Revenue Service Go to www.lrs.gov/Form4797 for instructions and the latest Information. Sequence No. 27 Names) shown on retum Identifying number Mona Inc 1 Enter the gross proceeds from sales or exchanges reported to you for 2019 on Form(s) 1099-B or 1099-s for substitute statement that you are including on Ine 2, 10, or 20. See Instructions 1 Part I Sales or Exchanges of Property Used in a Trade or Business and Involuntary Conversions From Other Than Casualty or Theft-Most Property Held More Than 1 Year (see instructions) lo) Depreciation Cost or other 2 (al Description b) Dato acquired (c) Dato sold allowodor (d) Gross basis, plus Ig) Gain or loss of property mo., day.yr.) mo, day. y.) salos price Subtract from the allowable since improvements and anquisition sum off and expense of sale 4 8,000 40,000 16,200 64,200 3 Gain, if any, from Form 4684, line 39 3 4 Section 1231 gain from Installment sales from Form 6252, line 26 or 37. 5 Section 1231 gain or loss) from like-kind exchanges from Form 8824 5 6 Gain, if any, from line 32. from other than casualty or theft 6 7 Combine Ines 2 through 6. Enter the gain or loss) here and on the appropriate line as follows 7 Partnerships and S corporations. Report the gain or loss) folowing the instructions for Form 1065, Schedule K, line 10, or Form 1120-S, Schedule K, line 9. Skip lines 8.9. 11. and 12 below. Individuals, partners, S corporation shareholders, and all others. If line 7 is zero or a loss, enter the amount from line 7 on line 11 below and skip Ines 8 and 9. If line 7 is a gain and you didn't have any prior year section 1231 losses, or they were recaptured in an earlier year, enter the gain from Ine 7 as a long-term capital gain on the Schedule D filed with your return and skip lines 8, 9, 11 and 12 below. 8 Nonrecaptured net section 1231 losses from prior years. See Instructions. 8 9 Subtract line from line 7. If zero or less, enter-O-. If line 9 is zero, enter the gain from Ine 7 on line 12 below. If line 9 is more than zero, enter the amount from the 8 on line 12 below and enter the gain from line 9 as a long-term capital gain on the Schedule D flled with your return. See instructions Part II Ordinary Gains and Losses (see instructions) 10 Ordinary gains and losses not included on Ines 11 through 16 (Include property held 1 year or less): Machine 3 14,600 1,660 18,000 4,000 60,200 -1,740 11 4,000 34,000 11 12 13 14 15 16 17 36,260 Loss, if any, from line 7. 12 Gain, if any, from ine 7 or amount from line 8. If applicable 13 Gain, if any, from line 31 14 Net gain or loss) from Form 4684, Ines 31 and 38a 15 Ordinary gain from installment sales from Form 6252, Ine 25 or 36 16 Ordinary gain or loss) from like-kind exchanges from Form 3824 17 Combine Ines 10 through 16 .. 18 For all except individual retums, enter the amount from line 17 on the appropriate line of your return and skip lines a and b below. For individual returns, complete ines a and b below. a If the loss on line 11 Includes a loss from Form 4684. Ine 35, column (b), enter that part of the loss here. Enter the loss from Income-producing property on Schedule A Form 1040 or Form 1040-SF), Ine 16. (Do not include any loss on property used as an employee.) identify as from "Form 4797, line 18a" See Instructions.. Redetermine the gain or loss) on line 17 excluding the loss, If any, on line 18a. Enter here and on Schedule 1 (Form 1040 or Form 1040-SA), Part I. line 4 For Paperwork Reduction Act Notice, see separate Instructions. Cat. No. 130661 18a 185 36,260 Form 4797 (2010)

Page 2 Form 4797 (2016) Part II Gain From Disposition of Property Under Sections 1245, 1250, 1252, 1254, and 1255 (see instructions) 19 (a) Description of section 1245, 1250, 1252, 1254, or 1255 property (b) Date acquired mo, day.yr.) A Machine 1 B Machine 2 с c) Date sold mo, day. yr.) Property A Property B Property C Property D These columns relate to the properties on Ines 19A through 190. 20 Gross sales price (Note: See line 1 before completing.) 21 Cost or other basis plus expense of sale. 22 Depreciation (or depletion allowed or allowable. 23 Adjusted basis. Subtract line 22 from line 21. 20 21 22 23 54,600 38,400 16,000 22,400 18.00 18,000 18,000 a 24 Total gain. Subtract line 23 from Iine 20 24 32,200 18,000 25 if section 1245 property a Depreciation allowed or allowable from Ine 22 25a 16,000 18,000 D Enter the smaller of line 24 or 25a. 25b 16,000 18,000 26 If section 1250 property: r straight the depreciation was used, enter-O-on ine 26g, except for a corporation subject to section 291. a Additional depreciation after 1975. See Instructions 28a b Applicable percentage multiplied by the smaller of line 24 or line 26a. See Instructions. 26b C Subtract line 26a from line 24. If residential rental property or line 24 Isn't more than line 26a, skip lines 26 and 26e 26c d Additional depreciation after 1969 and before 1976. 26d e Enter the smaller of line 26c or 26d 26e 1 Section 291 amount (corporations only) 261 g Add lines 260, 26e, and 261 269 27 If section 1252 property: Skip this section if you didn't dispose of farmland or if this form is being completed for a partnership a soll, water, and land clearing expenses. 27a b Une 27a multiplied by applicable percentage. See Instructions 27b Enter the smaller of line 24 or 27b 27c 28 If section 1254 property: a Intangible drilling and development costs, expenditures for development of mines and other natural deposits, mining exploration costs, and depletion. See Instructions 28a Enter the smaller of line 24 or 28a. 28b 29 If section 1255 property: a Applicable percentage of payments excluded from Income under section 126. See Instructions 29a b Enter the smaller of line 24 or 29a. See Instructions 29b Summary of Part III Gains. Complete property columns A through D through line 29b before going to line 30. 30 Total gains for al properties. Add property columns A through D, line 24 30 50,200 31 Add property columns A through D. Ines 25b, 269, 270, 285, and 29. Enter here and on line 13 31 34,000 32 Subtract line 31 from ine 30. Enter the portion from casualty or theft on Form 4684, line 33. Enter the portion from other than casualty or therton Form 4797, line 6 32 16,200 Part IV Recapture Amounts Under Sections 179 and 280F(b)(2) When Business Use Drops to 50% or Less (see instructions) (a) Section b) Section 179 280F(b)(2) 33 Section 179 expense deduction or depreciation allowable in prior years. 33 34 Recomputed depreciation. See Instructions. 35 Recapture amount. Subtract line 34 from line 33. See the instructions for where to report 35 Form 4797 2019) 34

Form 6252 Yes 0 Installment Sale Income OMB No. 1545-0228 Attach to your tax return. 2019 Department of the Treasury Use a separate form for each sale or other disposition of property on the Installment method. Atachment Intomal Revenue Service Go to www.irs.gov/Form 6252 for the latest Information. Saquance No. 67 Name(s) shown on ratum Identifying number Mona Inc 1 Description of property 2a Date acquired (mm/dd/yyyy) b Date sold (mm/dd/yyyy) 3 Was the property sold to a related party (see instructions) after May 14, 1980? If "No," skip line 4. No 4 Was the property you sold to a related party a marketable security? If "Yes," complete Part II. If "No." complete Part III for the year of sale and the 2 years after the year of sale. Yes No Part 1 Gross Profit and Contract Price. Complete this part for all years of the installment agreement 5 Selling price including mortgages and other debts. Don't include interest, whether stated or unstated 5 96,000 6 Mortgages, debts, and other liabilities the buyer assumed or took the property subject to see instructions) 6 7 Subtract line 6 from line 5 7 96,000! 8 Cost or other basis of property sold 8 64,000 9 Depreciation allowed or allowable 9 18,000 10 Adjusted basis. Subtract line 9 from line 8 10 46,000 11 Commissions and other expenses of sale 11 12 Income recapture from Form 4797, Part III (see instructions) 12 18,000 13 Add lines 10, 11, and 12. 13 64,000 14 Subtract line 13 from line 5. If zero or less, don't complete the rest of this form (see instructions) 14 32,000 15 If the property described on line 1 above was your main home, enter the amount of your excluded gain (see instructions). Otherwise, enter-O- 15 16 Gross profit. Subtract line 15 from line 14 16 32,000 17 Subtract line 13 from line 6. If zero or less, enter-O- 17 18 Contract price. Add line 7 and line 17 18 96,000 Part II Installment Sale Income. Complete this part for all years of the installment agreement. 19 Gross profit percentage (expressed as a decimal amount). Divide line 16 by line 18. (For years after the year of sale, see instructions) .3333 20 If this is the year of sale, enter the amount from line 17. Otherwise, enter-O-. 20 21 Payments received during year (see instructions). Don't include interest, whether stated or unstated 21 24,000 22 Add lines 20 and 21 22 24,000 23 Payments received in prior years (see instructions). Don't include interest, whether stated or unstated. 23 24 Installment sale income. Multiply line 22 by line 19 24 25 Enter the part of line 24 that is ordinary income under the recapture rules (see instructions) 25 26 Subtract line 25 from line 24. Enter here and on Schedule D or Form 4797 (see instructions) 26 Part III Related Party Installment Sale Income. Don't complete if you received the final payment this tax year. 27 Name, address, and taxpayer identifying number of related party 28 Did the related party resell or dispose of the property ("second disposition") during this tax year? No 29 If the answer to question 28 is "Yes," complete lines 30 through 37 below unless one of the following conditions is met Check the box that applies. a The second disposition was more than 2 years after the first disposition (other than dispositions of marketable securities). If this box is checked, enter the date of disposition (mm/dd/yyyy). b The first disposition was a sale or exchange of stock to the issuing corporation. The second disposition was an involuntary conversion and the threat of conversion occurred after the first disposition. d The second disposition occurred after the death of the original seller or buyer. It can be established to the satisfaction of the IRS that tax avoidance wasn't a principal purpose for either of the dispositions. If this box is checked, attach an explanation (see instructions). 30 Selling price of property sold by related party (see instructions) 30 31 Enter contract price from line 18 for year of first sale 31 32 Enter the smaller of line 30 or line 31 32 33 Total payments received by the end of your 2019 tax year (see instructions) 33 34 Subtract line 33 from line 32. If zero or less, enter-O- 34 35 Multiply line 34 by the gross profit percentage on line 19 for year of first sale 35 36 Enter the part of line 35 that is ordinary income under the recapture rules (see instructions) 36 37 Subtract line 36 from line 35. Enter here and on Schedule D or Form 4797 (see instructions) 37 For Paperwork Reduction Act Notice, see page 4. Cat. No. 13601R Form 6252 (2018) 19 0 al 8,000 8,000 Yes C 00 e

Form 1024 (2015) Namas) shown on tax return. Do not entor name and social security number if shown on other sida Page 2 Your social security number Part III Realized Gain or (Loss), Recognized Gain, and Basis of Like-Kind Property Received Caution: If you transferred and received (a) more than one group of like-kind properties or (b) cash or other (not like-kind) property, see Reporting of multi-asset exchanges in the instructions. Note: Complete lines 12 through 14 only if you gave up property that was not like-kind. Otherwise, go to line 15. 12 Fair market value (FMV) of other property given up 12 13 Adjusted basis of other property given up 13 14 Gain or (loss) recognized on other property given up. Subtract line 13 from line 12. Report the gain or (loss) in the same manner as if the exchange had been a sale 14 Caution: If the property given up was used previously or partly as a home, see Property used as home in the instructions. 15 Cash received, FMV of other property received, plus net liabilities assumed by other party, reduced (but not below zero) by any exchange expenses you incurred. See instructions 15 40,000 16 FMV of like-kind property you received 16 110,000 17 Add lines 15 and 16 17 150,000 18 Adjusted basis of like-kind property you gave up, net amounts paid to other party, plus any exchange expenses not used on line 15. See instructions 18 94,000 19 Realized gain or loss). Subtract line 18 from line 17 19 56,000 20 Enter the smaller of line 15 or line 19, but not less than zero 20 40,000 21 Ordinary income under recapture rules. Enter here and on Form 4797, line 16. See instructions 21 22 Subtract line 21 from line 20. If zero or less, enter-O-. If more than zero, enter here and on Schedule D or Form 4797, unless the installment method applies. See instructions 22 40,000 23 Recognized gain. Add lines 21 and 22. 23 40,000 24 Deferred gain or loss). Subtract line 23 from line 19. If a related party exchange, see instructions. 24 16,000 25 Basis of like-kind property received. Subtract line 15 from the sum of lines 18 and 23 25 94,000 Part IV Deferral of Gain From Section 1043 Conflict-of-Interest Sales Note: This part is to be used only by officers or employees of the executive branch of the federal government or judicial officers of the federal government (including certain spouses, minor or dependent children, and trustees as described in section 1043) for reporting nonrecognition of gain under section 1043 on the sale of property to comply with the conflict-of-interest requirements. This part can be used only if the cost of the replacement property is more than the basis of the divested property. 26 Enter the number from the upper right comer of your certificate of divestiture. Do not attach a copy of your certificate. Keep the certificate with your records.). 27 Description of divested property 0 28 Description of replacement property 29 29 30 30 Date divested property was sold (month, day, year) Sales price of divested property. See instructions Basis of divested property Realized gain. Subtract line 31 from line 30 Cost of replacement property purchased within 60 days after date of sale Subtract line 33 from line 30. If zero or less, enter-O- 31 32 31 32 33 33 34 34 35 35 Ordinary income under recapture rules. Enter here and on Form 4797, line 10. See instructions Subtract line 35 from line 34. If zero or less, enter-O-. If more than zero, enter here and on Schedule or Form 4797. See instructions. 36 36 37 Deferred gain. Subtract the sum of lines 35 and 36 from line 32 37 38 Basis of replacement property. Subtract line 37 from line 33 38 Form 8824 (2015)