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THE MANY FLAVORS OF ASSET SALES

April 28, 2004

The tax rules on asset sale gains are far from simple. Just ask John Kerry's tax preparer.

The presidential candidate has already amended his 2003 tax returns because his tax preparer misclassified a gain on the sale of a painting. Such gains are eligible for a reduced capital gain tax, but not the lowest capital gain rate. As a public service to those preparing returns for future candidates, we offer a quick rundown on the taxation of asset sales, from worst to best.

ORDINARY INCOME

Gains on the sale of some business assets are taxed as ordinary income, subject to the same regular tax rates - or alternative minimum tax rates - that apply to other income. The top ordinary income rate for individuals is 35%.

Oridnary gains include those on the sale of inventory and gain on the sale of depreciated property (but not buildings) that represents a recovery ("recapture") of prior depreciation.

Sometimes gain on depreciable property, including buildings, is ordinary even if the sale price is more than its original undepreciated cost, if the taxpayer has sold depreciable property at a loss in the previous five years.

A sale of a partnership interest can also be ordinary if a sale of assets by the partnership would result in ordinary income. Are you with us so far?

SHORT-TERM CAPITAL GAIN

Most property owned by non-business taxpayers is capital gain property of one sort or another. If the property sold at a gain has been held for one year or less, it is "short-term" gain. The tax rate for short-term gains is the same as ordinary income. The only tax-planning advantage of short-term capital gains is that they can be offset by short-term or long-term capital losses incurred in the same year (or those carried forward from prior years when net capital losses exceeded $3,000).

LONG-TERM COLLECTIBLES GAINS: 28%

If you sell a "collectible" that you have held for more than one year at a gain, the gain will be taxed at your ordinary rates or 28%, whichever is lower. For married taxpayers filing joint returns, this starts to be helpful in 2004 when taxable income hits the 33% bracket at $178,650. This is the provision that Senator Kerry's preparers mishandled.

The tax law defines a collectible as

   (A)  any work of art,

   (B)  any rug or antique,   

   (C)  any metal or gem,

   (D)  any stamp or coin, [or]

   (E)  any alcoholic beverage

GAIN ON DEPRECIATED COSTS OF BUILDINGS: 25%

A taxpayer who buys a building for business or rental use depreciates the building, deducting a portion of the building's cost each year for a period of years. For residential property, the depreciable life is currently 27.5 years; other buildings are depreciated over 39 years.

When a taxpayer sells a building, or other depreciable property, the cost used in determining whether the sale results in a gain is reduced by depreciation taken.

Example:

   A taxpayer purchases a duplex for 
   $275,000 and rents it for 10 years
   (we ignore the cost of land for now).  
   He then sells it for $300,000.  He would
   have taken a $10,000 depreciation 
   deduction each year, so his "basis" in
   the building would be $175,000:

   Original cost:         $275,000
   less depreciation:     (100,000)
   Basis:                 $175,000

The taxpayer would have a gain of $125,000 on the sale ($300,000 sale price less $175,000 basis). The gain attributable to the depreciation - $100,000 - would be taxed at a top rate of 25%. The remaining gain would normally be eligible for the lowest capital gain rate (unless the taxpayer had sold depreciable property for a loss in the prior five years).

The 25% rate is an advantage for joint filers with taxable income over $117,250; it also helps any taxpayers subject to alternative minimum tax, which has a minimum rate of 26%.

NIRVANA: THE 15% RATE

Any other long-term capital gains are eligible for the 15% maximum rate. Assets eligible for this rate include stocks, bonds (but beware of accrued interest and gains on bonds bought at a discount), land and similar investment property. Senator Kerry's tax preparers erroneously treated a sale of artwork as this kind of capital gain.

Long-term gains help all taxpayers. Taxpayers that would otherwise be in the 10% (joint income up to $14,300) or 15% (joint income up to $58,100) brackets pay a 5% maximum federal rate on "15%" long-term capital gains. If they hang on until 2008, this rate for low-bracket taxpayers is scheduled to fall to 0%.

WHAT ABOUT ALTERNATIVE MINUMUM TAX?

The same maximum rates apply in computing AMT.

A WORD ABOUT PARTNERSHIPS

Beware. If you are selling a partnership interest, many technical rules may affect the rates that apply.

WHAT ABOUT IOWA?

Unless you qualify for a special break for certain ultra-long-term capital gains (held at least 10 years), Iowa taxes capital gains at the same rate as ordinary income.

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