Publication 544: Sales and Other Dispositions of Assets; Ordinary or Capital Gain or Loss

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Table of Contents

Introduction

You must classify your gains and losses as either ordinary or capital (and your capital gains or losses as either short-term or long-term). You must do this to figure your net capital gain or loss.

For individuals, a net capital gain may be taxed at a lower tax rate than ordinary income. See Capital Gains Tax Rates in chapter 4. Your deduction for a net capital loss may be limited. See Treatment of Capital Losses in chapter 4.

Capital gain or loss.

Generally, you will have a capital gain or loss if you sell or exchange a capital asset. You also may have a capital gain if your section 1231 transactions result in a net gain.

Section 1231 transactions.

Section 1231 transactions are sales and exchanges of property held longer than 1 year and either used in a trade or business or held for the production of rents or royalties. They also include certain involuntary conversions of business or investment property, including capital assets. See Section 1231 Gains and Losses in chapter 3 for more information.

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Almost everything you own and use for personal purposes or investment is a capital asset. For exceptions, see Noncapital Assets, later.

Personal-use property.

Property held for personal use is a capital asset. Gain from a sale or exchange of that property is a capital gain. Loss from the sale or exchange of that property is not deductible. You can deduct a loss relating to personal-use property only if it results from a casualty or theft.

Investment property.

Investment property (such as stocks and bonds) is a capital asset, and a gain or loss from its sale or exchange is a capital gain or loss. This treatment does not apply to property used to produce rental income. See Business assets, later, under Noncapital Assets.

Release of restriction on land.

Amounts you receive for the release of a restrictive covenant in a deed to land are treated as proceeds from the sale of a capital asset.

A noncapital asset is property that is not a capital asset. The following kinds of property are not capital assets.

Property held mainly for sale to customers or property that will physically become part of merchandise for sale to customers. This includes stock in trade, inventory, and other property you hold mainly for sale to customers in your trade or business. Inventories are discussed in Publication 538, Accounting Periods and Methods.
Accounts or notes receivable acquired in the ordinary course of a trade or business for services rendered or from the sale of any properties described in (1).
Depreciable property used in your trade or business or as rental property (including section 197 intangibles defined later ), even if the property is fully depreciated (or amortized). Sales of this type of property are discussed in chapter 3.
Real property used in your trade or business or as rental property, even if the property is fully depreciated.
A copyright; a literary, musical, or artistic composition; a letter; a memorandum; or similar property (such as drafts of speeches, recordings, transcripts, manuscripts, drawings, or photographs)—
1. Created by your personal efforts,
2. Prepared or produced for you (in the case of a letter, memorandum, or similar property), or
3. Acquired from a person who created the property or for whom the property was prepared under circumstances (for example, by gift) entitling you to the basis of the person who created the property, or for whom it was prepared or produced.
U.S. Government publications you got from the government for free or for less than the normal sales price or that you acquired under circumstances entitling you to the basis of someone who got the publications for free or for less than the normal sales price.
Any commodities derivative financial instrument (discussed later) held by a commodities derivatives dealer unless it meets both the following requirements.
1. It is established to the satisfaction of the IRS that the instrument has no connection to the activities of the dealer as a dealer.
2. The instrument is clearly identified in the dealer's records as meeting (a) by the end of the day on which it was acquired, originated, or entered into.
Any hedging transaction (defined later) that is clearly identified as a hedging transaction by the end of the day on which it was acquired, originated, or entered into.
Supplies of a type you regularly use or consume in the ordinary course of your trade or business.

Property held mainly for sale to customers.

Stock in trade, inventory, and other property you hold mainly for sale to customers in your trade or business are not capital assets. Inventories are discussed in Publication 538.

Business assets.

Real property and depreciable property used in your trade or business or as rental property (including section 197 intangibles defined later under Dispositions of Intangible Property) are not capital assets. The sale or disposition of business property is discussed in chapter 3.

Letters and memorandums.

Letters, memorandums, and similar property (such as drafts of speeches, recordings, transcripts, manuscripts, drawings, or photographs) are not treated as capital assets (as discussed earlier) if your personal efforts created them or if they were prepared or produced for you. Nor is this property a capital asset if your basis in it is determined by reference to the person who created it or the person for whom it was prepared. For this purpose, letters and memorandums addressed to you are considered prepared for you. If letters or memorandums are prepared by persons under your administrative control, they are considered prepared for you whether or not you review them.

Commodities derivative financial instrument.

A commodities derivative financial instrument is a commodities contract or other financial instrument for commodities (other than a share of corporate stock, a beneficial interest in a partnership or trust, a note, bond, debenture, or other evidence of indebtedness, or a section 1256 contract) the value or settlement price of which is calculated or determined by reference to a specified index (as defined in section 1221(b) of the Internal Revenue Code).

Commodities derivative dealer.

A commodities derivative dealer is a person who regularly offers to enter into, assume, offset, assign, or terminate positions in commodities derivative financial instruments with customers in the ordinary course of a trade or business.

Hedging transaction.

A hedging transaction is any transaction you enter into in the normal course of your trade or business primarily to manage any of the following.

Risk of price changes or currency fluctuations involving ordinary property you hold or will hold.
Risk of interest rate or price changes or currency fluctuations for borrowings you make or will make, or ordinary obligations you incur or will incur.

This section discusses the rules that may apply to the sale or exchange of property between related persons. If these rules apply, gains may be treated as ordinary income and losses may not be deductible. See Transfers to Spouse in chapter 1 for rules that apply to spouses.

If a gain is recognized on the sale or exchange of property to a related person, the gain may be ordinary income even if the property is a capital asset. It is ordinary income if the sale or exchange is a depreciable property transaction or a controlled partnership transaction.

Depreciable property transaction.

Gain on the sale or exchange of property, including a leasehold or a patent application, that is depreciable property in the hands of the person who receives it is ordinary income if the transaction is either directly or indirectly between any of the following pairs of entities.

A person and the person's controlled entity or entities.
A taxpayer and any trust in which the taxpayer (or his or her spouse) is a beneficiary unless the beneficiary's interest in the trust is a remote contingent interest; that is, the value of the interest computed actuarially is 5% or less of the value of the trust property.
An executor and a beneficiary of an estate unless the sale or exchange is in satisfaction of a pecuniary bequest.
An employer (or any person related to the employer under rules (1), (2), or (3)) and a welfare benefit fund (within the meaning of section 419(e) of the Internal Revenue Code) that is controlled directly or indirectly by the employer (or any person related to the employer).

A person's controlled entity is either of the following.

A corporation in which more than 50% of the value of all outstanding stock, or a partnership in which more than 50% of the capital interest or profits interest, is directly or indirectly owned by or for that person.
An entity whose relationship with that person is one of the following.
1. A corporation and a partnership if the same persons own more than 50% in value of the outstanding stock of the corporation and more than 50% of the capital interest or profits interest in the partnership.
2. Two corporations that are members of the same controlled group as defined in section 1563(a) of the Internal Revenue Code, except that “more than 50%” is substituted for “at least 80%” in that definition.
3. Two S corporations, if the same persons own more than 50% in value of the outstanding stock of each corporation.
4. Two corporations, one of which is an S corporation, if the same persons own more than 50% in value of the outstanding stock of each corporation.

Controlled partnership transaction.

A gain recognized in a controlled partnership transaction may be ordinary income. The gain is ordinary income if it results from the sale or exchange of property that, in the hands of the party who receives it, is a noncapital asset such as trade accounts receivable, inventory, stock in trade, or depreciable or real property used in a trade or business.

A controlled partnership transaction is a transaction directly or indirectly between either of the following pairs of entities.

A partnership and a partner who directly or indirectly owns more than 50% of the capital interest or profits interest in the partnership.
Two partnerships, if the same persons directly or indirectly own more than 50% of the capital interests or profits interests in both partnerships.

Determining ownership.

In the transactions under Depreciable property transaction and Controlled partnership transaction, earlier, use the following rules to determine the ownership of stock or a partnership interest.

Stock or a partnership interest directly or indirectly owned by or for a corporation, partnership, estate, or trust is considered owned proportionately by or for its shareholders, partners, or beneficiaries. (However, for a partnership interest owned by or for a C corporation, this applies only to shareholders who directly or indirectly own 5% or more in value of the stock of the corporation.)
An individual is considered as owning the stock or partnership interest directly or indirectly owned by or for his or her family. Family includes only brothers, sisters, half-brothers, half-sisters, spouse, ancestors, and lineal descendants.
For purposes of applying (1) or (2), stock or a partnership interest constructively owned by a person under (1) is treated as actually owned by that person. But stock or a partnership interest constructively owned by an individual under (2) is not treated as owned by the individual for reapplying (2) to make another person the constructive owner of that stock or partnership interest.

A loss on the sale or exchange of property between related persons is not deductible. This applies to both direct and indirect transactions, but not to distributions of property from a corporation in a complete liquidation. The following are related persons.

Members of a family, including only brothers, sisters, half-brothers, half-sisters, spouse, ancestors (parents, grandparents, etc.), and lineal descendants (children, grandchildren, etc.).
An individual and a corporation if the individual directly or indirectly owns more than 50% in value of the outstanding stock of the corporation.
Two corporations that are members of the same controlled group as defined in section 267(f) of the Internal Revenue Code.
A trust fiduciary and a corporation if the trust or the grantor of the trust directly or indirectly owns more than 50% in value of the outstanding stock of the corporation.
A grantor and fiduciary, and the fiduciary and beneficiary, of any trust.
Fiduciaries of two different trusts, and the fiduciary and beneficiary of two different trusts, if the same person is the grantor of both trusts.
A tax-exempt educational or charitable organization and a person who directly or indirectly controls the organization, or a member of that person's family.
A corporation and a partnership if the same persons own more than 50% in value of the outstanding stock of the corporation and more than 50% of the capital interest or profits interest in the partnership.
Two S corporations if the same persons own more than 50% in value of the outstanding stock of each corporation.
Two corporations, one of which is an S corporation, if the same persons own more than 50% in value of the outstanding stock of each corporation.
An executor and a beneficiary of an estate unless the sale or exchange is in satisfaction of a pecuniary bequest.
Two partnerships if the same persons directly or indirectly own more than 50% of the capital interests or profits interests in both partnerships.
A person and a partnership if the person directly or indirectly owns more than 50% of the capital interest or profits interest in the partnership.

If a sale or exchange is between any of these related persons and involves the lump-sum sale of a number of blocks of stock or pieces of property, the gain or loss must be figured separately for each block of stock or piece of property. The gain on each item is taxable. The loss on any item is nondeductible. Gains from the sales of any of these items may not be offset by losses on the sales of any of the other items.

Partnership interests.

The nondeductible loss rule does not apply to a sale or exchange of an interest in the partnership between the related persons described in (12) or (13) above.

Controlled groups.

Losses on transactions between members of the same controlled group described in (3) earlier are deferred rather than denied.

For more information, see section 267(f) of the Internal Revenue Code.

Ownership of stock or partnership interests.

In determining whether an individual directly or indirectly owns any of the outstanding stock of a corporation or an interest in a partnership for a loss on a sale or exchange, the following rules apply.

Stock or a partnership interest directly or indirectly owned by or for a corporation, partnership, estate, or trust is considered owned proportionately by or for its shareholders, partners, or beneficiaries. (However, for a partnership interest owned by or for a C corporation, this applies only to shareholders who directly or indirectly own 5% or more in value of the stock of the corporation.)
An individual is considered as owning the stock or partnership interest directly or indirectly owned by or for his or her family. Family includes only brothers, sisters, half-brothers, half-sisters, spouse, ancestors, and lineal descendants.
An individual owning (other than by applying (2)) any stock in a corporation is considered to own the stock directly or indirectly owned by or for his or her partner.
For purposes of applying (1), (2), or (3), stock or a partnership interest constructively owned by a person under (1) is treated as actually owned by that person. But stock or a partnership interest constructively owned by an individual under (2) or (3) is not treated as owned by the individual for reapplying either (2) or (3) to make another person the constructive owner of that stock or partnership interest.

Indirect transactions.

You cannot deduct your loss on the sale of stock through your broker if under a prearranged plan a related person or entity buys the same stock you had owned. This does not apply to a cross-trade between related parties through an exchange that is purely coincidental and is not prearranged.

Property received from a related person.

If, in a purchase or exchange, you received property from a related person who had a loss that was not allowable and you later sell or exchange the property at a gain, you recognize the gain only to the extent it is more than the loss previously disallowed to the related person. This rule applies only to the original transferee.

Example 1.

Your brother sold stock to you for $7,600. His cost basis was $10,000. His loss of $2,400 was not deductible. You later sell the same stock to an unrelated party for $10,500, realizing a gain of $2,900 ($10,500 - $7,600). Your recognized gain is only $500, the gain that is more than the $2,400 loss not allowed to your brother.

Example 2.

Assume the same facts as in Example 1, except that you sell the stock for $6,900 instead of $10,500. Your recognized loss is only $700 ($7,600 - $6,900). You cannot deduct the loss not allowed to your brother.

This section discusses rules for determining the treatment of gain or loss from various dispositions of property.

The sale of a business usually is not a sale of one asset. Instead, all the assets of the business are sold. Generally, when this occurs, each asset is treated as being sold separately for determining the treatment of gain or loss.

A business usually has many assets. When sold, these assets must be classified as capital assets, depreciable property used in the business, real property used in the business, or property held for sale to customers, such as inventory or stock in trade. The gain or loss on each asset is figured separately. The sale of capital assets results in capital gain or loss. The sale of real property or depreciable property used in the business and held longer than 1 year results in gain or loss from a section 1231 transaction (discussed in chapter 3). The sale of inventory results in ordinary income or loss.

Partnership interests.

An interest in a partnership or joint venture is treated as a capital asset when sold. The part of any gain or loss from unrealized receivables or inventory items will be treated as ordinary gain or loss. For more information, see Disposition of Partner's Interest in Publication 541, Partnerships.

Corporation interests.

Your interest in a corporation is represented by stock certificates. When you sell these certificates, you usually realize capital gain or loss. For information on the sale of stock, see chapter 4 in Publication 550.

Corporate liquidations.

Corporate liquidations of property generally are treated as a sale or exchange. Gain or loss generally is recognized by the corporation on a liquidating sale of its assets. Gain or loss generally is recognized also on a liquidating distribution of assets as if the corporation sold the assets to the distributee at fair market value.

In certain cases in which the distributee is a corporation in control of the distributing corporation, the distribution may not be taxable. For more information, see Internal Revenue Code section 332 and its regulations.

Allocation of consideration paid for a business.

The sale of a trade or business for a lump sum is considered a sale of each individual asset rather than of a single asset. Except for assets exchanged under any nontaxable exchange rules, both the buyer and seller of a business must use the residual method (explained later) to allocate the consideration to each business asset transferred. This method determines gain or loss from the transfer of each asset and how much of the consideration is for goodwill and certain other intangible property. It also determines the buyer's basis in the business assets.

Consideration.

The buyer's consideration is the cost of the assets acquired. The seller's consideration is the amount realized (money plus the fair market value of property received) from the sale of assets.

Residual method.

The residual method must be used for any transfer of a group of assets that constitutes a trade or business and for which the buyer's basis is determined only by the amount paid for the assets. This applies to both direct and indirect transfers, such as the sale of a business or the sale of a partnership interest in which the basis of the buyer's share of the partnership assets is adjusted for the amount paid under section 743(b) of the Internal Revenue Code. Section 743(b) applies if a partnership has an election in effect under section 754 of the Internal Revenue Code.

A group of assets constitutes a trade or business if either of the following applies.

Goodwill or going concern value could, under any circumstances, attach to them.
The use of the assets would constitute an active trade or business under section 355 of the Internal Revenue Code.

The residual method provides for the consideration to be reduced first by the cash and general deposit accounts (including checking and savings accounts but excluding certificates of deposit). The consideration remaining after this reduction must be allocated among the various business assets in a certain order.

For asset acquisitions occurring after March 15, 2001, make the allocation among the following assets in proportion to (but not more than) their fair market value on the purchase date in the following order.

Certificates of deposit, U.S. Government securities, foreign currency, and actively traded personal property, including stock and securities.
Accounts receivable, other debt instruments, and assets that you mark to market at least annually for federal income tax purposes. However, see section 1.338–6(b)(2)(iii) of the regulations for exceptions that apply to debt instruments issued by persons related to a target corporation, contingent debt instruments, and debt instruments convertible into stock or other property.
Property of a kind that would properly be included in inventory if on hand at the end of the tax year or property held by the taxpayer primarily for sale to customers in the ordinary course of business.
All other assets except section 197 intangibles.
Section 197 intangibles (other than goodwill and going concern value).
Goodwill and going concern value (whether the goodwill or going concern value qualifies as a section 197 intangible).

If an asset described in (1) through (6) is includible in more than one category, include it in the lower number category. For example, if an asset is described in both (4) and (6), include it in (4).

Example.

The total paid in the January 10, 2003, sale of the assets of Company SKB is $21,000. No cash or deposit accounts or similar accounts were sold. The company's U.S. Government securities sold had a fair market value of $3,200. The only other asset transferred (other than goodwill and going concern value) was inventory with a fair market value of $15,000. Of the $21,000 paid for the assets of Company SKB, $3,200 is allocated to U.S. Government securities, $15,000 to inventory assets, and the remaining $2,800 to goodwill and going concern value.

Agreement.

The buyer and seller may enter into a written agreement as to the allocation of any consideration or the fair market value of any of the assets. This agreement is binding on both parties unless the IRS determines the amounts are not appropriate.

Reporting requirement.

Both the buyer and seller involved in the sale of business assets must report to the IRS the allocation of the sales price among section 197 intangibles and the other business assets. Use Form 8594 to provide this information. The buyer and seller should each attach Form 8594 to their federal income tax return for the year in which the sale occurred.

Intangible property is any personal property that has value but cannot be seen or touched. It includes such items as patents, copyrights, and the goodwill value of a business.

Gain or loss on the sale or exchange of amortizable or depreciable intangible property held longer than 1 year (other than an amount recaptured as ordinary income) is a section 1231 gain or loss. The treatment of section 1231 gain or loss and the recapture of amortization and depreciation as ordinary income are explained in chapter 3. See chapter 9 of Publication 535, Business Expenses, for information on amortizable intangible property and chapter 1 of Publication 946, How To Depreciate Property, for information on intangible property that can and cannot be depreciated. Gain or loss on dispositions of other intangible property is ordinary or capital depending on whether the property is a capital asset or a noncapital asset.

The following discussions explain special rules that apply to certain dispositions of intangible property.

Section 197 intangibles are certain intangible assets acquired after August 10, 1993 (after July 25, 1991, if chosen), and held in connection with the conduct of a trade or business or an activity entered into for profit whose costs are amortized over 15 years. They include the following assets.

Dispositions.

The following rules apply to dispositions of section 197 intangibles.

Covenant not to compete.

A covenant not to compete (or similar arrangement) that is a section 197 intangible cannot be treated as disposed of or worthless before you have disposed of your entire interest in the trade or business for which the covenant was entered into. Members of the same controlled group of corporations and commonly controlled businesses are treated as a single entity in determining whether a member has disposed of its entire interest in a trade or business.

Nondeductible loss.

You cannot deduct a loss from the disposition or worthlessness of a section 197 intangible you acquired in the same transaction (or series of related transactions) as another section 197 intangible you still hold. Instead, you must increase the adjusted basis of your retained section 197 intangible by the nondeductible loss. If you retain more than one section 197 intangible, increase each intangible's adjusted basis. Figure the increase by multiplying the nondeductible loss by a fraction, the numerator (top number) of which is the retained intangible's adjusted basis on the date of the loss and the denominator (bottom number) of which is the total adjusted basis of all retained intangibles on the date of the loss.

In applying this rule, members of the same controlled group of corporations and commonly controlled businesses are treated as a single entity. For example, a corporation cannot deduct a loss on the sale of a section 197 intangible if, after the sale, a member of the same controlled group retains other section 197 intangibles acquired in the same transaction as the intangible sold.

Anti-churning rules.

Anti-churning rules prevent a taxpayer from converting section 197 intangibles that do not qualify for amortization into property that would qualify for amortization. However, these rules do not apply to part of the basis of property acquired by certain related persons if the transferor chooses to do both the following.

Recognize gain on the transfer of the property.
Pay income tax on the gain at the highest tax rate.

If the transferor is a partnership or S corporation, the partnership or S corporation (not the partners or shareholders) can make the choice. But each partner or shareholder must pay the tax on his or her share of gain.

To make the choice, you, as the transferor, must attach a statement containing certain information to your income tax return for the year of the transfer. You must file the tax return by the due date (including extensions). You must also notify the transferee of the choice in writing by the due date of the return.

If you timely filed your return without making the choice, you can make the choice by filing an amended return within 6 months after the due date of the return (excluding extensions). Attach the statement to the amended return and write “Filed pursuant to section 301.9100–2” at the top of the statement. File the amended return at the same address the original return was filed.

For more information about making the choice, see section 1.197–2(h)(9) of the regulations. For information about reporting the tax on your income tax return, see the instructions for Form 4797.

The transfer of a patent by an individual is treated as a sale or exchange of a capital asset held longer than 1 year. This applies even if the payments for the patent are made periodically during the transferee's use or are contingent on the productivity, use, or disposition of the patent. For information on the treatment of gain or loss on the transfer of capital assets, see chapter 4.

This treatment applies to your transfer of a patent if you meet all the following conditions.

Holder.

You are the holder of a patent if you are either of the following.

The individual whose effort created the patent property and who qualifies as the original and first inventor.
The individual who bought an interest in the patent from the inventor before the invention was tested and operated successfully under operating conditions and who is neither related to, nor the employer of, the inventor.

All substantial rights.

All substantial rights to patent property are all rights that have value when they are transferred. A security interest (such as a lien), or a reservation calling for forfeiture for nonperformance, is not treated as a substantial right for these rules and may be kept by you as the holder of the patent.

All substantial rights to a patent are not transferred if any of the following apply to the transfer.

The rights are limited geographically within a country.
The rights are limited to a period less than the remaining life of the patent.
The rights are limited to fields of use within trades or industries and are less than all the rights that exist and have value at the time of the transfer.
The rights are less than all the claims or inventions covered by the patent that exist and have value at the time of the transfer.

Related persons.

This tax treatment does not apply if the transfer is directly or indirectly between you and a related person as defined earlier under Nondeductible Loss, with the following changes.

Members of your family include your spouse, ancestors, and lineal descendants, but not your brothers, sisters, half-brothers, or half-sisters.
Substitute “25% or more” ownership for “more than 50%” in that listing.

If you fit within the definition of a related person independent of family status, the brother-sister exception in (1), earlier, does not apply. For example, a transfer between a brother and a sister as beneficiary and fiduciary of the same trust is a transfer between related persons. The brother-sister exception does not apply because the trust relationship is independent of family status.

If you transfer or renew a franchise, trademark, or trade name for a price contingent on its productivity, use, or disposition, the amount you receive generally is treated as an amount realized from the sale of a noncapital asset. A franchise includes an agreement that gives one of the parties the right to distribute, sell, or provide goods, services, or facilities within a specified area.

Significant power, right, or continuing interest.

If you keep any significant power, right, or continuing interest in the subject matter of a franchise, trademark, or trade name that you transfer or renew, the amount you receive is ordinary royalty income rather than an amount realized from a sale or exchange.

A significant power, right, or continuing interest in a franchise, trademark, or trade name includes, but is not limited to, the following rights in the transferred interest.

A right to disapprove any assignment of the interest, or any part of it.
A right to end the agreement at will.
A right to set standards of quality for products used or sold, or for services provided, and for the equipment and facilities used to promote such products or services.
A right to make the recipient sell or advertise only your products or services.
A right to make the recipient buy most supplies and equipment from you.
A right to receive payments based on the productivity, use, or disposition of the transferred item of interest if those payments are a substantial part of the transfer agreement.

If you own a tract of land and, to sell or exchange it, you subdivide it into individual lots or parcels, the gain normally is ordinary income. However, you may receive capital gain treatment on at least part of the proceeds provided you meet certain requirements. See section 1237 of the Internal Revenue Code.

Standing timber held as investment property is a capital asset. Gain or loss from its sale is reported as a capital gain or loss on Schedule D (Form 1040). If you held the timber primarily for sale to customers, it is not a capital asset. Gain or loss on its sale is ordinary business income or loss. It is reported in the gross receipts or sales and cost of goods sold items of your return.

Farmers who cut timber on their land and sell it as logs, firewood, or pulpwood usually have no cost or other basis for that timber. These sales constitute a very minor part of their farm businesses. In these cases, amounts realized from such sales, and the expenses of cutting, hauling, etc., are ordinary farm income and expenses reported on Schedule F (Form 1040), Profit or Loss From Farming.

Different rules apply if you owned the timber longer than 1 year and choose to either:

Under the rules discussed below, disposition of the timber is treated as a section 1231 transaction. See chapter 3. Gain or loss is reported on Form 4797.

Christmas trees.

Evergreen trees, such as Christmas trees, that are more than 6 years old when severed from their roots and sold for ornamental purposes are included in the term timber. They qualify for both rules discussed below.

Choice to treat cutting as a sale or exchange.

Under the general rule, the cutting of timber results in no gain or loss. It is not until a sale or exchange occurs that gain or loss is realized. But if you owned or had a contractual right to cut timber, you can choose to treat the cutting of timber as a section 1231 transaction in the year the timber is cut. Even though the cut timber is not actually sold or exchanged, you report your gain or loss on the cutting for the year the timber is cut. Any later sale results in ordinary business income or loss. See Example, later.

To choose this treatment, you must:

Own, or hold a contractual right to cut, the timber for a period of more than 1 year before it is cut, and
Cut the timber for sale or for use in your trade or business.

Making the choice.

You make the choice on your return for the year the cutting takes place by including in income the gain or loss on the cutting and including a computation of the gain or loss. You do not have to make the choice in the first year you cut timber. You can make it in any year to which the choice would apply. If the timber is partnership property, the choice is made on the partnership return. This choice cannot be made on an amended return.

Once you have made the choice, it remains in effect for all later years unless you cancel it.

Canceling a post-1986 choice.

You can cancel a choice you made for a tax year beginning after 1986 only if you can show undue hardship and get the approval of the IRS. Thereafter, you may not make any new choice unless you have the approval of the IRS.

Canceling a pre-1987 choice.

You can cancel a choice you made for a tax year beginning before 1987 without the approval of the IRS. You can cancel the choice by attaching a statement to your tax return for the year the cancellation is to be effective. If you make this cancellation, which can be made only once, you can make a new choice without the approval of the IRS. Any further cancellation will require the approval of the IRS.

The statement must include all the following information.

Your name, address, and taxpayer identification number.
The year the cancellation is effective and the timber to which it applies.
That the cancellation being made is of the choice to treat the cutting of timber as a sale or exchange under section 631(a) of the Internal Revenue Code.
That the cancellation is being made under section 311(d) of Public Law 99–514.
That you are entitled to make the cancellation under section 311(d) of Public Law 99–514 and temporary regulations section 301.9100–7T.

Gain or loss.

Your gain or loss on the cutting of standing timber is the difference between its adjusted basis for depletion and its fair market value on the first day of your tax year in which it is cut.

Your adjusted basis for depletion of cut timber is based on the number of units (feet board measure, log scale, or other units) of timber cut during the tax year and considered to be sold or exchanged. Your adjusted basis for depletion is also based on the depletion unit of timber in the account used for the cut timber, and should be figured in the same manner as shown in section 611 of the Internal Revenue Code and regulation section 1.611–3.

Timber depletion is discussed in chapter 10 in Publication 535.

Example.

In April 2003, you had owned 4,000 MBF (1,000 board feet) of standing timber longer than 1 year. It had an adjusted basis for depletion of $40 per MBF. You are a calendar year taxpayer. On January 1, 2003, the timber had a fair market value (FMV) of $350 per MBF. It was cut in April for sale. On your 2003 tax return, you choose to treat the cutting of the timber as a sale or exchange. You report the difference between the fair market value and your adjusted basis for depletion as a gain. This amount is reported on Form 4797 along with your other section 1231 gains and losses to figure whether it is treated as capital gain or as ordinary gain. You figure your gain as follows.

FMV of timber January 1, 2003	$1,400,000
Minus: Adjusted basis for depletion	160,000
Section 1231 gain	$1,240,000

The fair market value becomes your basis in the cut timber and a later sale of the cut timber including any by-product or tree tops will result in ordinary business income or loss.

Cutting contract.

You must treat the disposal of standing timber under a cutting contract as a section 1231 transaction if all the following apply to you.

You are the owner of the timber.
You held the timber longer than 1 year before its disposal.
You kept an economic interest in the timber.

The difference between the amount realized from the disposal of the timber and its adjusted basis for depletion is treated as gain or loss on its sale. Include this amount on Form 4797 along with your other section 1231 gains or losses to figure whether it is treated as capital or ordinary gain or loss.

Date of disposal.

The date of disposal is the date the timber is cut. However, if you receive payment under the contract before the timber is cut, you can choose to treat the date of payment as the date of disposal.

This choice applies only to figure the holding period of the timber. It has no effect on the time for reporting gain or loss (generally when the timber is sold or exchanged).

To make this choice, attach a statement to the tax return filed by the due date (including extensions) for the year payment is received. The statement must identify the advance payments subject to the choice and the contract under which they were made.

If you timely filed your return for the year you received payment without making the choice, you still can make the choice by filing an amended return within 6 months after the due date for that year's return (excluding extensions). Attach the statement to the amended return and write “Filed pursuant to section 301.9100–2” at the top of the statement. File the amended return at the same address the original return was filed.

Owner.

The owner of timber is any person who owns an interest in it, including a sublessor and the holder of a contract to cut the timber. You own an interest in timber if you have the right to cut it for sale on your own account or for use in your business.

Economic interest.

You have kept an economic interest in standing timber if, under the cutting contract, the expected return on your investment is conditioned on the cutting of the timber.

Tree stumps.

Tree stumps are a capital asset if they are on land held by an investor who is not in the timber or stump business as a buyer, seller, or processor. Gain from the sale of stumps sold in one lot by such a holder is taxed as a capital gain. However, tree stumps held by timber operators after the saleable standing timber was cut and removed from the land are considered by-products. Gain from the sale of stumps in lots or tonnage by such operators is taxed as ordinary income.

Gold, silver, gems, stamps, coins, etc., are capital assets except when they are held for sale by a dealer. Any gain or loss from their sale or exchange generally is a capital gain or loss. If you are a dealer, the amount received from the sale is ordinary business income.

You must treat the disposal of coal (including lignite) or iron ore mined in the United States as a section 1231 transaction if both the following apply to you.

For this rule, the date the coal or iron ore is mined is considered the date of its disposal.

Your gain or loss is the difference between the amount realized from disposal of the coal or iron ore and the adjusted basis you use to figure cost depletion (increased by certain expenses not allowed as deductions for the tax year). This amount is included on Form 4797 along with your other section 1231 gains and losses.

You are considered an owner if you own or sublet an economic interest in the coal or iron ore in place. If you own only an option to buy the coal in place, you do not qualify as an owner. In addition, this gain or loss treatment does not apply to income realized by an owner who is a co-adventurer, partner, or principal in the mining of coal or iron ore.

The expenses of making and administering the contract under which the coal or iron ore was disposed of and the expenses of preserving the economic interest kept under the contract are not allowed as deductions in figuring taxable income. Rather, their total, along with the adjusted depletion basis, is deducted from the amount received to determine gain. If the total of these expenses plus the adjusted depletion basis is more than the amount received, the result is a loss.

Special rule.

The above treatment does not apply if you directly or indirectly dispose of the iron ore or coal to any of the following persons.

A related person whose relationship to you would result in the disallowance of a loss (see Nondeductible Loss under Sales and Exchanges Between Related Persons, earlier).
An individual, trust, estate, partnership, association, company, or corporation owned or controlled directly or indirectly by the same interests that own or control your business.

Recognized gain on the disposition or termination of any position held as part of certain conversion transactions is treated as ordinary income. This applies if substantially all your expected return is attributable to the time value of your net investment (like interest on a loan) and the transaction is any of the following.