Example

Jane Smith is single. At the beginning of 2001, she owned and operated Jane's Dress Shop at 25 Main Street, Smalltown, Virginia. On March 16, she traded the land and building where she operated her dress shop for other land and a building around the corner at 97 Oak Street. She then opened the J. Smith Hardware Store. Jane also sold all the equipment she had used in her dress shop, as well as a vacant lot across the street from the shop used for customer parking. She reports these transactions as shown in the filled-in Form 4797 and Form 8824 at the end of this chapter.

Form 4797

Jane sold the equipment she used in her dress shop for $3,000. She originally paid $6,000 for it on January 20, 1986, and had fully depreciated it. She realized a gain of $3,000. Because the gain was less than the $6,000 depreciation taken, all her gain is ordinary income from depreciation. This amount is reported in Part III of Form 4797 and entered in Part II on line 13.

The adjusted basis of the vacant lot (acquired in 1980) was $6,000 and its sales price was $8,000. Jane reports her $2,000 gain from the sale in Part I of Form 4797.

Jane had a nonrecaptured net section 1231 loss of $1,200. She shows this loss in Part I on line 8. Since the net section 1231 gain of $2,000 is more than the nonrecaptured loss, that gain is treated as ordinary gain only up to the loss. Therefore, the loss of $1,200 on line 8 is entered as an ordinary gain in Part II of Form 4797 on line 12. The loss is also subtracted from the $2,000 gain on line 7. The $800 balance is entered on line 9.

Form 8824

Because Jane entered into a like-kind exchange by trading her business real property for other business real property, she must report the transaction on Form 8824 and attach the form to her tax return.

On lines 16 and 17 of Form 8824, Jane enters the fair market value of her new property, $120,000, consisting of $95,000 for the building and $25,000 for the land. On line 18 she enters the adjusted basis of the old property, $100,000, consisting of $36,919 for the building and $63,081 for the land. Her realized gain on line 19 is $20,000. Under the like-kind exchange rules, this gain is not recognized. Jane enters "-0-" on line 20.

However, because there is additional depreciation of $9,274 on the old building, Jane must determine whether any of her gain has to be recognized as ordinary income under the recapture rules. The old building has an FMV of $90,000. Had the transaction been a cash sale, Jane's realized gain on the building would have been $53,081 ($90,000 - $36,919). The additional depreciation is less than that amount, so her ordinary income due to the additional depreciation would have been $9,274. That amount is less than the $95,000 fair market value of the new building, and there is no ordinary income recognized on the exchange. The $9,274 ordinary income that does not have to be reported is carried over to the new building as additional depreciation. Jane enters "-0-" on line 21 of Form 8824 and line 16 of Form 4797.

All of Jane's $20,000 gain is deferred (line 24). The basis of her new property (line 25) is $100,000, the same as the adjusted basis of her old property. Of that amount, $79,167 [($95,000 × $120,000) × $100,000] is allocated to the building and $20,833 [($25,000 × $120,000) × $100,000] is allocated to the land.

Summary

The entries in Part II, Form 4797, show an ordinary gain of $4,200, which is carried to line 14, Form 1040.

The entries in Part I, Form 4797, result in a long-term capital gain of $800 from section 1231 transactions. This is carried to line 11, Schedule D (Form 1040), column (f).

Form 4797 pg 1

Form 4797 pg 2

Form 8824 pg 1

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