Form 4797 questions to ask before reporting an asset sale

When a client tells you they sold their business, the sales price may be settled, but the tax work is just beginning. Before that sale makes its way onto Form 4797, Sales of Business Property, there's a deceptively simple question to answer: How much of that price belongs to each asset?

How is a lump-sum sales price allocated among multiple assets?

If the sale is an applicable asset acquisition under §1060, the seller and purchaser each allocate their consideration using the residual method and report the allocation on Form 8594, Asset Acquisition Statement Under Section 1060. The seller's consideration is the amount realized, which may include liabilities assumed by the buyer, while the purchaser's is the cost of the acquired assets. A written allocation agreement generally binds both parties unless the IRS determines the allocation or value is inappropriate.

Otherwise, use a reasonable, fact-supported allocation, often based on relative fair market values (FMVs), and calculate the gain or loss and any depreciation recapture separately for each asset.

The allocation can't be adjusted simply to reduce depreciation recapture. Apply expenses related to one asset to that asset, and allocate common selling expenses using a reasonable, consistent method that follows the applicable sales-price allocation rules.

How is land reported when sold with a building?

Allocate the sales price and selling expenses between the land and building based on their relative FMVs. Land is not depreciable, so calculate its gain separately from the building's gain and depreciation recapture. For property used in a trade or business and held for more than one year, building gain generally begins in Part III of Form 4797. Land generally goes in Part I as §1231 property, even if the software uses one disposition screen. However, certain farmland held for less than 10 years may be subject to §1252 ordinary-income recapture before the remaining gain receives §1231 treatment.

How do you distinguish between §1245 and §1250 property?

Depreciable tangible personal property, such as equipment and furniture, is generally §1245 property, while buildings and their structural components are generally §1250 property. A warehouse or cold-storage building is generally §1250 property, but separately identified refrigeration equipment may be §1245 property.

Does qualified improvement property count as §1245 property?

No. Qualified improvement property (QIP) is generally §1250 property. However, if the taxpayer claimed a §179 deduction for QIP, the portion of its basis attributable to that deduction is treated as §1245 property. On sale, recognized gain up to the amount of that deduction may be recaptured as ordinary income.

How do the §1245 and §1250 rules affect gain?

For §1245 property, gain is ordinary income to the extent of depreciation allowed or allowable; any remaining gain may receive §1231 treatment. For most §1250 property depreciated using the straight-line method and held more than one year, the depreciation-related portion is generally unrecaptured §1250 gain rather than ordinary-income recapture for noncorporate taxpayers. For C corporations, §291 may require additional ordinary income. Additional depreciation above straight-line can produce ordinary-income recapture.

Is unrecaptured §1250 gain always taxed at 25%?

No. The 25% rate is the maximum federal rate on unrecaptured §1250 gain, not an automatic flat rate. The taxpayer's actual rate depends on taxable income and the Schedule D Tax Worksheet in the Instructions for Schedule D (Form 1040), Capital Gains and Losses.

How does the five-year §1231 lookback affect current gain?

Current net §1231 gain is recharacterized as ordinary income to the extent of nonrecaptured net §1231 losses from the previous five years. Any remaining gain is treated as long-term capital gain, so review the prior five returns when estimating the tax consequences.

Is depreciation allowed in the year an asset is sold?

Generally, yes, unless the asset was placed in service and disposed of during the same tax year or its basis has already been fully recovered. Calculate disposition-year depreciation using the applicable half-year, mid-quarter or mid-month convention.

How should obsolete assets be handled before a planned sale?

An asset cannot be removed from depreciation records solely to avoid allocating sale proceeds or recognizing recapture. If it was actually abandoned or otherwise disposed of before the sale, document the disposition and determine whether any gain or loss results, considering its adjusted basis and any amount realized. Abandonment requires voluntarily and permanently giving up possession and use without transferring the asset to someone else. If the asset remained part of the sale, include it in the allocation, even if fully depreciated.

A defensible allocation and reliable depreciation records help support the Form 4797 reporting. For more worked examples, view NATP's Working Through Form 4797 Using Real Case Studies on-demand webinar.

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