When you sell income producing property related to your business, like machinery or a moonwalk. You have to report that sale somewhere on your return. The result can be an ordinary gain or loss or a capital gain or loss. Unlike income generating property not used in a business, property used in an organized business must be reported using Form 4797, Sale of Business Property. This article touches on the major aspects of this form, and should be used as a general introduction and beginner’s guide.
One of the purposes of Form 4797 is to determine what portion of any gain from the sale or exchange of property held in a business context needs to be deemed ordinary gains instead of capital gains due to prior depreciation allowed or allowable on those assets. In other words, depreciation was taken, and then this depreciation is “recaptured” by categorizing certain gains that would otherwise be capital as ordinary. If any of the sections articulated in this article ring a bell for property that you have sold in the context of your business, then you should seek the help of a professional because most likely there is some kind of recapture of depreciation that must be taken into account. Again, this is an overview of the sale of business property through the lens of Form 4797.
To begin, line 1 of Form 4797 asks you to list the proceeds found on Form 1099-S or Form 1099-B. When they refer to Form 1099-S, the IRS is referencing the proceeds from the sale of real property. For the 1099-B, they are referring to commodities sold by traders in the business of market-to-market trades, which is outside the scope of this article, but you would probably know if that sort of thing applies to you.
Part I – Section 1231 Transactions
Part I of Form 4797 pertains to the sale or exchange of Section 1231 property, the majority of which will have been held for greater than one year. So in this respect, these gains or losses are capital in nature. This property includes the following: 1) real property held in a trade or business held for one year or more 2) timber, 3) coal, 4) iron ore, 5) cattle and horses used for draft, breeding, dairy, or sport and held for 24 months or more, 6) sale of other livestock used for draft, breeding, dairy, or sport, and held for 12 months or more 7) certain unharvested crops, and 8) involuntary conversions of trade or business property or capital assets held more than one year in the context of a trade or business. Section 1231 does not include: 1) inventory for sale to customers, 2) most intellectual property, such as patents, inventions, etcetera, and 3) publications of the American government.
Part II – Transactions not Reported on Part I or III
Part II is reserved for transactions that were not included in Part I or Part III, and also the sale of non-capital assets not reported on Schedule D. These are certain transactions that are frequently peculiar and not very common, but they are worth mentioning because Form 4797 itself is fairly common for the disposition of business property. In this vein, if you: 1) held property for less than a year in your business, 2) received a gain or loss from preferred stock through an applicable financial institution, 3) were a securities or commodities trader who made a market-to-market election and had gains or losses through those activities, 4) had losses from small business investment company stock, 5) had losses from Section 1244 (small business) stock up to $50,000 ($100,000 married filing jointly). Suffice it to say, that if any of these scenarios apply to you, then you should probably seek outside counsel in preparing your return because your return is fairly complicated. However, it’s important to know some of the transactions that pertain to this portion of Form 4797.
Part III – Gain from Disposition of Property under Sections 1245, 1250, 1252, 1254, and 1255
Part III is where recapture of depreciation will cause gains that would otherwise be capital, to be classified as ordinary. Again, this is a complicated and eccentric calculation for each section of property articulated. In this vein, I’ll simply be going over the types of property that have the reconfiguration of gains applied to them.
Section 1245 property includes: personal property; property used in manufacturing; research facilities; facilities used in the bulk storage of fungible commodities; the portion of real property that has had its basis reduced by any of a litany of types of depreciation, deductions, and amortization including section 179; structures that serve a single purpose livestock or horticultural purpose; storage facilities for the distribution of petroleum or products of petroleum; and railroad gradings or tunnel bore. The big take away here is for personal property, which is a huge category. Treat any gain attributable to the lesser of depreciation/amortization or the gain from disposition of that property as ordinary income, even if it would otherwise be considered a capital gain.
Section 1250 property is property that is not and has never been section 1245 property and includes things such as leaseholds. Note that once property becomes section 1245 property, if there is such an occurrence, it can never go back to being section 1250 property. The gain on section 1250 is treated as ordinary income to the extent of something called “additional depreciation.” This has a special meaning but in a nutshell is any depreciation taken on that property that was greater than the amount taken using the straight line method.
Section 1252 property stems from the sale or disposition of farmland. The ordinary income depreciation recapture associated with these sales pertains to deductions under section 175, which relate to soil and water conservation.
Section 1254 property relates to the gain from disposition of an interest in oil, gas, geothermal, or other mineral properties. You must treat as ordinary income any portion of the gain from the sale that is equivalent to the amount of expenses that were deducted as intangible drilling costs, depletion, mine exploration costs, and development costs under section 263, 616, and 617.
Section 1255 property pertains to payments made to the taxpayer that are excludable from gross income and are associated with environmental laws, such as the Federal Water Pollution Control Act. Having to deal with Section 1255 is farfetched for most taxpayers. However, like I’ve stated numerous times, if this applies to you, you’ll probably know it. The amount of the recapture, meaning the amount of the payments that cause the otherwise capital gain to be treated as an ordinary gain, start at 100% and then decrease by 10 percent for each year the property was held beyond the first 10 years after the payments were received. Again, you’ll know if this applies to you because this paragraph will have meaning to you in terms of receiving exempt income payments under a federal environmental law.
Part IV – Section 179 Recapture
This section is pretty straight forward, at least as this form goes. If the business use of your capital for the business that has been depreciated under the section 179 deduction ever drops below 50%, you must recapture a certain amount of depreciation figured by the amount of normal depreciation that would have been available to the property under the normal MACRS deductions had that property been used 100% for business purposes subtracted by the amount of depreciation that would have been available in the aggregate had the property always been used for less than 50% business use. Add this amount of depreciation back into income on Schedule C, line 6. Note that this amount is subject to the self-employment tax, figured using Schedule SE, Self-Employment Tax, and furthermore, should also be added back into the basis of the property from which it was figured.
Note, this section actually has nothing to do with selling property. All that matters is that the business use of your property drops below 50% at any time in its tenure in your business. If that happens, then you must use the foregoing computation to compute the amount of depreciation to include in gross income on your Schedule C, line6.
Form 4797 is pretty much the nightmare that it appears to be. It’s an insane miasma of parts that seem to shock even the seasoned tax practitioner. So, I wouldn’t recommend tackling it alone. Therefore, if you’re confronted with Form 4797, don’t hesitate to give Dino Tax Co a call at (713) 397-4678 or email firstname.lastname@example.org. Also, don’t forget to like us on Facebook at www.facebook.com/dinotaxco.