It is no surprise that many pond professionals fail to understand the tax ramifications of disposing of business property. Under our current rules, which are often confusing and complex, there are numerous ways to dispose of business assets: selling them, scrapping them, exchanging them for another business asset, or even giving them away, just to name a few. This variety of options makes it extremely important to consider asset dispositions before they happen.
New, more restrictive rules created as part of the 2017 Tax Cuts and Jobs Act (TCJA), mean that a pond or water feature’s business can no longer treat the trade-in of business vehicles, equipment or machinery as a non-taxable event. Instead, when old assets are traded for new ones, income taxes must be paid on the gain, if any.
Even with a simple, straightforward sale, the tax treatment can be quite complex. The legal structure of the pond business usually determines the tax rate that applies on capital gain income. Unlike individuals who enjoy preferential tax treatment for long-term capital gain, incorporated businesses have capital gains added to the operation’s ordinary income and are taxed at the corporate tax rate.
The capital gains realized by pass-through entities like partnerships and S corporations flows through to the owner’s individual income tax return. Therefore, the capital gain income is taxed at rates that apply to individuals.
In most cases, gains and losses are netted against each other. If the ultimate result is a net loss, that amount is fully deductible against ordinary income. If the result is a net gain, then the income is considered long-term capital gain, whose tax treatment is more favorable than ordinary income.
Of course, if there is gain on the sale of tangible personal property, tax is levied in two ways. Either property held long-term is taxed as a capital gain and qualifies for special tax rates, or part is taxed as ordinary income.
Spread Out the Bill
Any pond professional can, of course, elect not to use the installment method of reporting sales by including all the gain in income in the sale year. Many pond businesses, however, generally sell their unused or unneeded equipment, machinery and other business assets using the so-called installment method, creating income as payments are received.
The amount of gain from installment sales is measured by the gross sale proceeds minus selling expenses and is expressed as a gross profit percentage. This percentage is then applied to each payment as it is received, and gain is included in each year in which the seller receives a payment.
In almost all cases, the seller in an installment sale will compensate the buyer by incorporating interest payments into the transaction. This interest paid by the buyer is taxed separately at ordinary tax rates, while the actual gain is taxed at the individual short-term or long-term rates, depending on the length of time the underlaying asset was held. Again, it’s ordinary income treatment for incorporated businesses.
In order to qualify as an installment sale under our tax rules, the seller sells property to a buyer and must receive at least one payment in a year other than the sale year. However, while most pond businesses can usually sell assets on the installment method, that doesn’t apply to inventory-type property. A pond business can, for example, sell one of its service vehicles using the installment method, but not its products or inventory goods.
Limited Exchanges & Trade-Ins
It wasn’t too long ago (before the passage of the TCJA) that a pond business could exchange so-called “like-kind” business property and be able to defer any taxable gain until the property was ultimately sold. Deferring a tax bill for the gain from a sale until a later year can, in many cases, reduce the amount of tax, as opposed to reporting the entire gain in the current tax year, when profits and tax rates may be higher.
Beginning with exchanges after the Dec. 31, 2017 passage of the TCJA, deferring recognition of gain using a like-kind exchange only works with real estate. Real estate, called real property by the IRS, includes land and generally anything built on or attached to it.
With a 1031, a so-called “tax-free” exchange, rather than paying taxes when a capital gain is realized, those proceeds can be reinvested into an asset of a similar value or “like-kind.” Unfortunately, as mentioned, after Jan. 1, 2018, exchanges of personal or intangible property such as equipment machinery and vehicles no longer qualify for nonrecognition of gain or loss in like-kind exchanges.
Abandon & Forget it
Losses from the abandonment of business or investment property are generally deductible as ordinary losses — as long as the abandonment is not treated as a sale or exchange. Of course, abandonment of property held for personal use is nondeductible.
For property to be abandoned, two things must occur. First, the property’s owner, the pond business, must take action that clearly shows it has given up rights to the property. Second, the owner must show intention that demonstrates that they have knowingly relinquished control of it.
In other words, the abandoned property’s owner must take clear, decisive action that indicates they no longer want the property. Inaction — that is, failure to do something with the property, or non-usage — is not enough to demonstrate that the right to the property has been relinquished, even where such non-use has occurred for a long period of time.
An involuntary conversion is an event that is not initiated by the pond professional. It involves the conversion of a garden pond operation’s property into similar or dissimilar property due to condemnation (actual or threatened), theft, seizure, requisition usually instigated by a government unit, or destruction. An involuntary conversion does not include any voluntary acts, such as when the pond business destroys its own property.
Consider these three examples of involuntary conversions:
A condemnation is generally defined as the taking of private property for public use. If the pond business disposes of property because of imminent condemnation of the property, the business must provide evidence that the condemnation was initiated by the authorities and that it reasonably believed that the property would be taken. When the condemned property is not replaced, the difference between any reimbursement and the property’s basis or book value is usually a capital gain. If the compensation is less than the property’s basis, a capital loss results. What’s more, an involuntary conversion resulting from when property is stolen or destroyed is usually a capital loss.
Another instance of an involuntary conversion is when a business’s property is completely destroyed or stolen. Loss is calculated by figuring out the property’s adjusted basis or book value. This is usually the original price, plus any increase in value to account for improvements, minus a decrease, such as any depreciation claimed.
Finally, a casualty loss is the result of an identifiable event that is sudden, unexpected or unusual and causes damage, destruction or loss of property. The TCJA greatly reduced the casualty loss deduction for losses to personal property. Fortunately, the new restriction does not apply to casualty losses involving business property such as buildings, equipment or vehicles used by the pond builder, retailer or supplier.
Payback is Expensive
Depreciation recapture is a provision in U.S. tax law that allows the IRS to collect taxes on any profitable sale of business assets where a fast or bonus write-off has been taken. Since depreciation of an asset reduces ordinary income, a portion of the gain from the disposal of the asset must be reported as ordinary income, rather than the more favorable capital gain.
Our tax laws lay out recapture rules for two types of depreciable property: personal and real property that performs specific functions (Section 1245) and buildings and their structural components (Section 1250). For all depreciable property that is sold, the pond business must recapture or pay back the portion of the gain that resulted from earlier depreciation deductions as ordinary income.
When a building or its structural components are sold, the recapture is taxed differently. Most assets will be depreciated under a straight-line method and a 25% recapture tax rate applied. Some real property may be depreciated using a rate that is higher than straight-line. In those cases, recapture up to the amount of straight-line depreciation is still taxed at 25%, with any remaining gain attributable to depreciation recaptured as ordinary income. The rest of the gain will be treated as long-term capital gain.
Unused, unworkable, unrepairable or obsolete business property can be disposed of in a variety of ways. Under our tax rules, a disposition occurs when a pond professional sells, exchanges, retires, abandons, suffers an involuntary conversion or destroys the operation’s property or equipment. Because of the complexity of our tax laws, and with each course action having its fair share of consequences, professional guidance may be necessary to reap the most benefit and the smallest tax bill.
With 25 years of professional experience in taxes and finance, Mark E. Battersby is empowered to write about unique and topical subjects. Although no reputable professional should ever render specific advice at arm’s length, he does craft unbiased, interesting, informative, and accurate articles. Mr. Battersby currently writes for publications in a variety of fields. His topical columns are syndicated in many publications each week.