Fact Pattern: Two transactions for a sole proprietorship were made during the current year. These were the only sales or exchanges of capital assets or Sec. 1231 assets (there were no unrecaptured Sec. 1231 losses from the previous year).
A machine used in the business was sold for $40,000. It cost $33,000 when purchased 3 years ago, and its adjusted tax basis when sold was $21,000. Depreciation had been recorded on an accelerated basis; straight-line depreciation would have been $9,900.
A $50,000 insurance recovery on a small warehouse destroyed by fire was received. It was used in the business and depreciated using the straight-line method. Its adjusted tax basis at the date of the fire was $52,400. A new warehouse was rebuilt at a cost of $60,000.
Question: 14 What is the combined tax effect of these two transactions on the proprietor’s Form 1040?
A. $7,000 long-term capital gain and $9,600 ordinary income.
B. $4,600 long-term capital gain and $12,000 ordinary income.
C. $7,000 long-term capital gain; $12,000 ordinary income; and $2,400 ordinary loss.
D. $19,000 long-term capital gain and $2,400 ordinary loss.
Answer (C) is correct.
The sale of the machine resulted in a realized gain of $19,000 (amount realized of $40,000 less the adjusted basis of $21,000). A portion of the gain equal to the depreciation already taken is recaptured as ordinary income under Sec. 1245 ($12,000). The remaining $7,000 of gain is characterized under Sec. 1231 and will be treated as long-term capital gain. The involuntary conversion results in a $2,400 realized ordinary loss ($50,000 amount realized less $52,400 adjusted basis). Realized losses on involuntary conversions are fully recognized.
Can someone kindly explain how the 12,000 Ordinary income was calculated. Thank you.
FAR 05/27/14; 786/110 - Done !
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