Milestone One: Gross Income and Capital Gains I. Memorandum E. Identify the tax consequences on the sale or exchange of the land consistent

Milestone One:  Gross Income and Capital Gains

  1. Memorandum
    1. Identify the tax consequences on the sale or exchange of the land consistent with capital gain rules.  Consider the selling expense, broker’s fees, closing costs, appraisals and surveys and the correct schedule form to complete.

Capital gains or capital losses refer to the gain or loss which is realized on the disposal of capital property. A property that provides a long-term and enduring benefit to its owner(s) is considered capital property.  As such, disposals of this type of property do not often occur over a taxpayer’s lifetime. Properties that have potential for capital gains are those that are held for personal use and enjoyment, for investment purposes, or for the purpose of assisting in generating business activity. Calculating a capital gain or loss for tax purposes is a simple matter.  However, tax treatment is a significant factor to consider when an investment in capital assets is being contemplated. It is important to recognize when a gain or loss on the sale or exchange of property is classified as a capital gain or loss as opposed to income or loss from business. Since neither the Internal Revenue Code nor the Treasury (Tax) Regulations provide specific guidelines, establishing if a transaction is a capital one can be very complex.

The intended purpose of the property at the time of acquisition determines whether the taxpayer can classify its distribution as a capital transaction.  If property is purchased with the sole purpose of resale, then the proceeds of the sale would result in a business income or loss, not a capital transaction.  However, it the property is purchased with a long-term or “enduring benefit” then the proceeds of its sale or exchange would be considered a capital gain or loss.

The taxpayer would need to complete both a Schedule D (Form 1040) and Form 8949 to account for the sale of the capital asset.

II.        Conclusion

  • Describe the after tax effects on the client’s cash flow based on the sale of the land that is needed to provide the funds necessary to start the business.  Consider including capital gains tax rules.

If personally owned land is converted into a business use, then the fair market value of the property becomes the basis at the time of the conversion.  The capital gain or loss on the disposition is calculated as follows:

Proceeds of disposition                                   $XXXX

Less:    Adjusted cost basis        $XXX

Expenses of disposition $XXX            $XXX

Net Capital Gain or Loss                                            $XXXX

Assuming the net capital gain is $8,550,000 (FMV less ADB and expenses of disposition) this would be the taxable amount.  If we assume our taxpayer is in the 33% tax bracket, the tax rate for the long term capital gain would be 15%.

  • Explain whether or not the client and his child should take a salary or cash distribution according to tax purposes and IRS code and regulations.  Consider the type of business and the tax effect whether it is salary, dividends or cash withdrawal.

If the business is a sole proprietorship or partnership, the owner(s) would take a draw.  If the business is set up as a corporation, dividends are paid.  However, if the owner works for the company he or she is considered an employee and is paid a salary.  It is very important when issuing salaries (or guaranteed payments) to owners that the compensation be in line with the degree of involvement in generating income, the type of work performed and the prevailing local rate of compensation for similar work and expertise.   Salaries paid to owners are deducted before the corporate income tax is calculated which may assist in providing a larger deduction against the corporate income tax. 


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