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Filing 1040nr Ez

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Filing 1040nr Ez

Filing 1040nr ez 3. Filing 1040nr ez   Ordinary or Capital Gain or Loss for Business Property Table of Contents Introduction Topics - This chapter discusses: Useful Items - You may want to see: Section 1231 Gains and LossesNonrecaptured section 1231 losses. Filing 1040nr ez Depreciation RecaptureSection 1245 Property Section 1250 Property Installment Sales Gifts Transfers at Death Like-Kind Exchanges and Involuntary Conversions Multiple Properties Introduction When you dispose of business property, your taxable gain or loss is usually a section 1231 gain or loss. Filing 1040nr ez Its treatment as ordinary or capital is determined under rules for section 1231 transactions. Filing 1040nr ez When you dispose of depreciable property (section 1245 property or section 1250 property) at a gain, you may have to recognize all or part of the gain as ordinary income under the depreciation recapture rules. Filing 1040nr ez Any remaining gain is a section 1231 gain. Filing 1040nr ez Topics - This chapter discusses: Section 1231 gains and losses Depreciation recapture Useful Items - You may want to see: Publication 534 Depreciating Property Placed in Service Before 1987 537 Installment Sales 547 Casualties, Disasters and Thefts 551 Basis of Assets 946 How To Depreciate Property Form (and Instructions) 4797 Sales of Business Property See chapter 5 for information about getting publications and forms. Filing 1040nr ez Section 1231 Gains and Losses Section 1231 gains and losses are the taxable gains and losses from section 1231 transactions (discussed below). Filing 1040nr ez Their treatment as ordinary or capital depends on whether you have a net gain or a net loss from all your section 1231 transactions. Filing 1040nr ez If you have a gain from a section 1231 transaction, first determine whether any of the gain is ordinary income under the depreciation recapture rules (explained later). Filing 1040nr ez Do not take that gain into account as section 1231 gain. Filing 1040nr ez Section 1231 transactions. Filing 1040nr ez   The following transactions result in gain or loss subject to section 1231 treatment. Filing 1040nr ez Sales or exchanges of real property or depreciable personal property. Filing 1040nr ez This property must be used in a trade or business and held longer than 1 year. Filing 1040nr ez Generally, property held for the production of rents or royalties is considered to be used in a trade or business. Filing 1040nr ez Depreciable personal property includes amortizable section 197 intangibles (described in chapter 2 under Other Dispositions). Filing 1040nr ez Sales or exchanges of leaseholds. Filing 1040nr ez The leasehold must be used in a trade or business and held longer than 1 year. Filing 1040nr ez Sales or exchanges of cattle and horses. Filing 1040nr ez The cattle and horses must be held for draft, breeding, dairy, or sporting purposes and held for 2 years or longer. Filing 1040nr ez Sales or exchanges of other livestock. Filing 1040nr ez This livestock does not include poultry. Filing 1040nr ez It must be held for draft, breeding, dairy, or sporting purposes and held for 1 year or longer. Filing 1040nr ez Sales or exchanges of unharvested crops. Filing 1040nr ez The crop and land must be sold, exchanged, or involuntarily converted at the same time and to the same person and the land must be held longer than 1 year. Filing 1040nr ez You cannot keep any right or option to directly or indirectly reacquire the land (other than a right customarily incident to a mortgage or other security transaction). Filing 1040nr ez Growing crops sold with a lease on the land, though sold to the same person in the same transaction, are not included. Filing 1040nr ez Cutting of timber or disposal of timber, coal, or iron ore. Filing 1040nr ez The cutting or disposal must be treated as a sale, as described in chapter 2 under Timber and Coal and Iron Ore. Filing 1040nr ez Condemnations. Filing 1040nr ez The condemned property must have been held longer than 1 year. Filing 1040nr ez It must be business property or a capital asset held in connection with a trade or business or a transaction entered into for profit, such as investment property. Filing 1040nr ez It cannot be property held for personal use. Filing 1040nr ez Casualties and thefts. Filing 1040nr ez The casualty or theft must have affected business property, property held for the production of rents and royalties, or investment property (such as notes and bonds). Filing 1040nr ez You must have held the property longer than 1 year. Filing 1040nr ez However, if your casualty or theft losses are more than your casualty or theft gains, neither the gains nor the losses are taken into account in the section 1231 computation. Filing 1040nr ez For more information on casualties and thefts, see Publication 547. Filing 1040nr ez Property for sale to customers. Filing 1040nr ez   A sale, exchange, or involuntary conversion of property held mainly for sale to customers is not a section 1231 transaction. Filing 1040nr ez If you will get back all, or nearly all, of your investment in the property by selling it rather than by using it up in your business, it is property held mainly for sale to customers. Filing 1040nr ez Example. Filing 1040nr ez You manufacture and sell steel cable, which you deliver on returnable reels that are depreciable property. Filing 1040nr ez Customers make deposits on the reels, which you refund if the reels are returned within a year. Filing 1040nr ez If they are not returned, you keep each deposit as the agreed-upon sales price. Filing 1040nr ez Most reels are returned within the 1-year period. Filing 1040nr ez You keep adequate records showing depreciation and other charges to the capitalized cost of the reels. Filing 1040nr ez Under these conditions, the reels are not property held for sale to customers in the ordinary course of your business. Filing 1040nr ez Any gain or loss resulting from their not being returned may be capital or ordinary, depending on your section 1231 transactions. Filing 1040nr ez Copyrights. Filing 1040nr ez    The sale of a copyright, a literary, musical, or artistic composition, or similar property is not a section 1231 transaction if your personal efforts created the property, or if you acquired the property in a way that entitled you to the basis of the previous owner whose personal efforts created it (for example, if you receive the property as a gift). Filing 1040nr ez The sale of such property results in ordinary income and generally is reported in Part II of Form 4797. Filing 1040nr ez Treatment as ordinary or capital. Filing 1040nr ez   To determine the treatment of section 1231 gains and losses, combine all your section 1231 gains and losses for the year. Filing 1040nr ez If you have a net section 1231 loss, it is ordinary loss. Filing 1040nr ez If you have a net section 1231 gain, it is ordinary income up to the amount of your nonrecaptured section 1231 losses from previous years. Filing 1040nr ez The rest, if any, is long-term capital gain. Filing 1040nr ez Nonrecaptured section 1231 losses. Filing 1040nr ez   Your nonrecaptured section 1231 losses are your net section 1231 losses for the previous 5 years that have not been applied against a net section 1231 gain. Filing 1040nr ez Therefore, if in any of your five preceding tax years you had section 1231 losses, a net gain for the current year from the sale of section 1231 assets is ordinary gain to the extent of your prior losses. Filing 1040nr ez These losses are applied against your net section 1231 gain beginning with the earliest loss in the 5-year period. Filing 1040nr ez Example. Filing 1040nr ez In 2013, Ben has a $2,000 net section 1231 gain. Filing 1040nr ez To figure how much he has to report as ordinary income and long-term capital gain, he must first determine his section 1231 gains and losses from the previous 5-year period. Filing 1040nr ez From 2008 through 2012 he had the following section 1231 gains and losses. Filing 1040nr ez Year Amount 2008 -0- 2009 -0- 2010 ($2,500) 2011 -0- 2012 $1,800 Ben uses this information to figure how to report his net section 1231 gain for 2013 as shown below. Filing 1040nr ez 1) Net section 1231 gain (2013) $2,000 2) Net section 1231 loss (2010) ($2,500)   3) Net section 1231 gain (2012) 1,800   4) Remaining net section 1231 loss from prior 5 years ($700)   5) Gain treated as  ordinary income $700 6) Gain treated as long-term  capital gain $1,300 Depreciation Recapture If you dispose of depreciable or amortizable property at a gain, you may have to treat all or part of the gain (even if otherwise nontaxable) as ordinary income. Filing 1040nr ez To figure any gain that must be reported as ordinary income, you must keep permanent records of the facts necessary to figure the depreciation or amortization allowed or allowable on your property. Filing 1040nr ez This includes the date and manner of acquisition, cost or other basis, depreciation or amortization, and all other adjustments that affect basis. Filing 1040nr ez On property you acquired in a nontaxable exchange or as a gift, your records also must indicate the following information. Filing 1040nr ez Whether the adjusted basis was figured using depreciation or amortization you claimed on other property. Filing 1040nr ez Whether the adjusted basis was figured using depreciation or amortization another person claimed. Filing 1040nr ez Corporate distributions. Filing 1040nr ez   For information on property distributed by corporations, see Distributions to Shareholders in Publication 542, Corporations. Filing 1040nr ez General asset accounts. Filing 1040nr ez   Different rules apply to dispositions of property you depreciated using a general asset account. Filing 1040nr ez For information on these rules, see Publication 946. Filing 1040nr ez Section 1245 Property A gain on the disposition of section 1245 property is treated as ordinary income to the extent of depreciation allowed or allowable on the property. Filing 1040nr ez See Gain Treated as Ordinary Income, later. Filing 1040nr ez Any gain recognized that is more than the part that is ordinary income from depreciation is a section 1231 gain. Filing 1040nr ez See Treatment as ordinary or capital under Section 1231 Gains and Losses, earlier. Filing 1040nr ez Section 1245 property defined. Filing 1040nr ez   Section 1245 property includes any property that is or has been subject to an allowance for depreciation or amortization and that is any of the following types of property. Filing 1040nr ez Personal property (either tangible or intangible). Filing 1040nr ez Other tangible property (except buildings and their structural components) used as any of the following. Filing 1040nr ez See Buildings and structural components below. Filing 1040nr ez An integral part of manufacturing, production, or extraction, or of furnishing transportation, communications, electricity, gas, water, or sewage disposal services. Filing 1040nr ez A research facility in any of the activities in (a). Filing 1040nr ez A facility in any of the activities in (a) for the bulk storage of fungible commodities (discussed on the next page). Filing 1040nr ez That part of real property (not included in (2)) with an adjusted basis reduced by (but not limited to) the following. Filing 1040nr ez Amortization of certified pollution control facilities. Filing 1040nr ez The section 179 expense deduction. Filing 1040nr ez Deduction for clean-fuel vehicles and certain refueling property. Filing 1040nr ez Deduction for capital costs incurred in complying with Environmental Protection Agency sulfur regulations. Filing 1040nr ez Deduction for certain qualified refinery property. Filing 1040nr ez Deduction for qualified energy efficient commercial building property. Filing 1040nr ez Amortization of railroad grading and tunnel bores, if in effect before the repeal by the Revenue Reconciliation Act of 1990. Filing 1040nr ez (Repealed by Public Law 99-514, Tax Reform Act of 1986, section 242(a). Filing 1040nr ez ) Certain expenditures for child care facilities if in effect before repeal by Public Law 101-58, Omnibus Budget Reconciliation Act of 1990, section 11801(a)(13) (except with regards to deductions made prior to November 5, 1990). Filing 1040nr ez Expenditures to remove architectural and transportation barriers to the handicapped and elderly. Filing 1040nr ez Deduction for qualified tertiary injectant expenses. Filing 1040nr ez Certain reforestation expenditures. Filing 1040nr ez Deduction for election to expense qualified advanced mine safety equipment property. Filing 1040nr ez Single purpose agricultural (livestock) or horticultural structures. Filing 1040nr ez Storage facilities (except buildings and their structural components) used in distributing petroleum or any primary product of petroleum. Filing 1040nr ez Any railroad grading or tunnel bore. Filing 1040nr ez Buildings and structural components. Filing 1040nr ez   Section 1245 property does not include buildings and structural components. Filing 1040nr ez The term building includes a house, barn, warehouse, or garage. Filing 1040nr ez The term structural component includes walls, floors, windows, doors, central air conditioning systems, light fixtures, etc. Filing 1040nr ez   Do not treat a structure that is essentially machinery or equipment as a building or structural component. Filing 1040nr ez Also, do not treat a structure that houses property used as an integral part of an activity as a building or structural component if the structure's use is so closely related to the property's use that the structure can be expected to be replaced when the property it initially houses is replaced. Filing 1040nr ez   The fact that the structure is specially designed to withstand the stress and other demands of the property and cannot be used economically for other purposes indicates it is closely related to the use of the property it houses. Filing 1040nr ez Structures such as oil and gas storage tanks, grain storage bins, silos, fractionating towers, blast furnaces, basic oxygen furnaces, coke ovens, brick kilns, and coal tipples are not treated as buildings, but as section 1245 property. Filing 1040nr ez Facility for bulk storage of fungible commodities. Filing 1040nr ez   This term includes oil or gas storage tanks and grain storage bins. Filing 1040nr ez Bulk storage means the storage of a commodity in a large mass before it is used. Filing 1040nr ez For example, if a facility is used to store oranges that have been sorted and boxed, it is not used for bulk storage. Filing 1040nr ez To be fungible, a commodity must be such that one part may be used in place of another. Filing 1040nr ez   Stored materials that vary in composition, size, and weight are not fungible. Filing 1040nr ez Materials are not fungible if one part cannot be used in place of another part and the materials cannot be estimated and replaced by simple reference to weight, measure, and number. Filing 1040nr ez For example, the storage of different grades and forms of aluminum scrap is not storage of fungible commodities. Filing 1040nr ez Gain Treated as Ordinary Income The gain treated as ordinary income on the sale, exchange, or involuntary conversion of section 1245 property, including a sale and leaseback transaction, is the lesser of the following amounts. Filing 1040nr ez The depreciation and amortization allowed or allowable on the property. Filing 1040nr ez The gain realized on the disposition (the amount realized from the disposition minus the adjusted basis of the property). Filing 1040nr ez A limit on this amount for gain on like-kind exchanges and involuntary conversions is explained later. Filing 1040nr ez For any other disposition of section 1245 property, ordinary income is the lesser of (1) earlier or the amount by which its fair market value is more than its adjusted basis. Filing 1040nr ez See Gifts and Transfers at Death, later. Filing 1040nr ez Use Part III of Form 4797 to figure the ordinary income part of the gain. Filing 1040nr ez Depreciation taken on other property or taken by other taxpayers. Filing 1040nr ez   Depreciation and amortization include the amounts you claimed on the section 1245 property as well as the following depreciation and amortization amounts. Filing 1040nr ez Amounts you claimed on property you exchanged for, or converted to, your section 1245 property in a like-kind exchange or involuntary conversion. Filing 1040nr ez Amounts a previous owner of the section 1245 property claimed if your basis is determined with reference to that person's adjusted basis (for example, the donor's depreciation deductions on property you received as a gift). Filing 1040nr ez Depreciation and amortization. Filing 1040nr ez   Depreciation and amortization that must be recaptured as ordinary income include (but are not limited to) the following items. Filing 1040nr ez Ordinary depreciation deductions. Filing 1040nr ez Any special depreciation allowance you claimed. Filing 1040nr ez Amortization deductions for all the following costs. Filing 1040nr ez Acquiring a lease. Filing 1040nr ez Lessee improvements. Filing 1040nr ez Certified pollution control facilities. Filing 1040nr ez Certain reforestation expenses. Filing 1040nr ez Section 197 intangibles. Filing 1040nr ez Childcare facility expenses made before 1982, if in effect before the repeal of IRC 188. Filing 1040nr ez Franchises, trademarks, and trade names acquired before August 11, 1993. Filing 1040nr ez The section 179 deduction. Filing 1040nr ez Deductions for all the following costs. Filing 1040nr ez Removing barriers to the disabled and the elderly. Filing 1040nr ez Tertiary injectant expenses. Filing 1040nr ez Depreciable clean-fuel vehicles and refueling property (minus the amount of any recaptured deduction). Filing 1040nr ez Environmental cleanup costs. Filing 1040nr ez Certain reforestation expenses. Filing 1040nr ez Qualified disaster expenses. Filing 1040nr ez Any basis reduction for the investment credit (minus any basis increase for credit recapture). Filing 1040nr ez Any basis reduction for the qualified electric vehicle credit (minus any basis increase for credit recapture). Filing 1040nr ez Example. Filing 1040nr ez You file your returns on a calendar year basis. Filing 1040nr ez In February 2011, you bought and placed in service for 100% use in your business a light-duty truck (5-year property) that cost $10,000. Filing 1040nr ez You used the half-year convention and your MACRS deductions for the truck were $2,000 in 2011 and $3,200 in 2012. Filing 1040nr ez You did not take the section 179 deduction. Filing 1040nr ez You sold the truck in May 2013 for $7,000. Filing 1040nr ez The MACRS deduction in 2013, the year of sale, is $960 (½ of $1,920). Filing 1040nr ez Figure the gain treated as ordinary income as follows. Filing 1040nr ez 1) Amount realized $7,000 2) Cost (February 2011) $10,000   3) Depreciation allowed or allowable (MACRS deductions: $2,000 + $3,200 + $960) 6,160   4) Adjusted basis (subtract line 3 from line 2) $3,840 5) Gain realized (subtract line 4 from line 1) $3,160 6) Gain treated as ordinary income (lesser of line 3 or line 5) $3,160 Depreciation on other tangible property. Filing 1040nr ez   You must take into account depreciation during periods when the property was not used as an integral part of an activity or did not constitute a research or storage facility, as described earlier under Section 1245 property. Filing 1040nr ez   For example, if depreciation deductions taken on certain storage facilities amounted to $10,000, of which $6,000 is from the periods before their use in a prescribed business activity, you must use the entire $10,000 in determining ordinary income from depreciation. Filing 1040nr ez Depreciation allowed or allowable. Filing 1040nr ez   The greater of the depreciation allowed or allowable is generally the amount to use in figuring the part of gain to report as ordinary income. Filing 1040nr ez However, if in prior years, you have consistently taken proper deductions under one method, the amount allowed for your prior years will not be increased even though a greater amount would have been allowed under another proper method. Filing 1040nr ez If you did not take any deduction at all for depreciation, your adjustments to basis for depreciation allowable are figured by using the straight line method. Filing 1040nr ez   This treatment applies only when figuring what part of gain is treated as ordinary income under the rules for section 1245 depreciation recapture. Filing 1040nr ez Multiple asset accounts. Filing 1040nr ez   In figuring ordinary income from depreciation, you can treat any number of units of section 1245 property in a single depreciation account as one item if the total ordinary income from depreciation figured by using this method is not less than it would be if depreciation on each unit were figured separately. Filing 1040nr ez Example. Filing 1040nr ez In one transaction you sold 50 machines, 25 trucks, and certain other property that is not section 1245 property. Filing 1040nr ez All of the depreciation was recorded in a single depreciation account. Filing 1040nr ez After dividing the total received among the various assets sold, you figured that each unit of section 1245 property was sold at a gain. Filing 1040nr ez You can figure the ordinary income from depreciation as if the 50 machines and 25 trucks were one item. Filing 1040nr ez However, if five of the trucks had been sold at a loss, only the 50 machines and 20 of the trucks could be treated as one item in determining the ordinary income from depreciation. Filing 1040nr ez Normal retirement. Filing 1040nr ez   The normal retirement of section 1245 property in multiple asset accounts does not require recognition of gain as ordinary income from depreciation if your method of accounting for asset retirements does not require recognition of that gain. Filing 1040nr ez Section 1250 Property Gain on the disposition of section 1250 property is treated as ordinary income to the extent of additional depreciation allowed or allowable on the property. Filing 1040nr ez To determine the additional depreciation on section 1250 property, see Additional Depreciation, below. Filing 1040nr ez Section 1250 property defined. Filing 1040nr ez   This includes all real property that is subject to an allowance for depreciation and that is not and never has been section 1245 property. Filing 1040nr ez It includes a leasehold of land or section 1250 property subject to an allowance for depreciation. Filing 1040nr ez A fee simple interest in land is not included because it is not depreciable. Filing 1040nr ez   If your section 1250 property becomes section 1245 property because you change its use, you can never again treat it as section 1250 property. Filing 1040nr ez Additional Depreciation If you hold section 1250 property longer than 1 year, the additional depreciation is the actual depreciation adjustments that are more than the depreciation figured using the straight line method. Filing 1040nr ez For a list of items treated as depreciation adjustments, see Depreciation and amortization under Gain Treated as Ordinary Income, earlier. Filing 1040nr ez For the treatment of unrecaptured section 1250 gain, see Capital Gains Tax Rate, later. Filing 1040nr ez If you hold section 1250 property for 1 year or less, all the depreciation is additional depreciation. Filing 1040nr ez You will not have additional depreciation if any of the following conditions apply to the property disposed of. Filing 1040nr ez You figured depreciation for the property using the straight line method or any other method that does not result in depreciation that is more than the amount figured by the straight line method; you held the property longer than 1 year; and, if the property was qualified property, you made a timely election not to claim any special depreciation allowance. Filing 1040nr ez In addition, if the property was in a renewal community, you must not have elected to claim a commercial revitalization deduction for property placed in service before January 1, 2010. Filing 1040nr ez The property was residential low-income rental property you held for 162/3 years or longer. Filing 1040nr ez For low-income rental housing on which the special 60-month depreciation for rehabilitation expenses was allowed, the 162/3 years start when the rehabilitated property is placed in service. Filing 1040nr ez You chose the alternate ACRS method for the property, which was a type of 15-, 18-, or 19-year real property covered by the section 1250 rules. Filing 1040nr ez The property was residential rental property or nonresidential real property placed in service after 1986 (or after July 31, 1986, if the choice to use MACRS was made); you held it longer than 1 year; and, if the property was qualified property, you made a timely election not to claim any special depreciation allowance. Filing 1040nr ez These properties are depreciated using the straight line method. Filing 1040nr ez In addition, if the property was in a renewal community, you must not have elected to claim a commercial revitalization deduction. Filing 1040nr ez Depreciation taken by other taxpayers or on other property. Filing 1040nr ez   Additional depreciation includes all depreciation adjustments to the basis of section 1250 property whether allowed to you or another person (as carryover basis property). Filing 1040nr ez Example. Filing 1040nr ez Larry Johnson gives his son section 1250 property on which he took $2,000 in depreciation deductions, of which $500 is additional depreciation. Filing 1040nr ez Immediately after the gift, the son's adjusted basis in the property is the same as his father's and reflects the $500 additional depreciation. Filing 1040nr ez On January 1 of the next year, after taking depreciation deductions of $1,000 on the property, of which $200 is additional depreciation, the son sells the property. Filing 1040nr ez At the time of sale, the additional depreciation is $700 ($500 allowed the father plus $200 allowed the son). Filing 1040nr ez Depreciation allowed or allowable. Filing 1040nr ez   The greater of depreciation allowed or allowable (to any person who held the property if the depreciation was used in figuring its adjusted basis in your hands) generally is the amount to use in figuring the part of the gain to be reported as ordinary income. Filing 1040nr ez If you can show that the deduction allowed for any tax year was less than the amount allowable, the lesser figure will be the depreciation adjustment for figuring additional depreciation. Filing 1040nr ez Retired or demolished property. Filing 1040nr ez   The adjustments reflected in adjusted basis generally do not include deductions for depreciation on retired or demolished parts of section 1250 property unless these deductions are reflected in the basis of replacement property that is section 1250 property. Filing 1040nr ez Example. Filing 1040nr ez A wing of your building is totally destroyed by fire. Filing 1040nr ez The depreciation adjustments figured in the adjusted basis of the building after the wing is destroyed do not include any deductions for depreciation on the destroyed wing unless it is replaced and the adjustments for depreciation on it are reflected in the basis of the replacement property. Filing 1040nr ez Figuring straight line depreciation. Filing 1040nr ez   The useful life and salvage value you would have used to figure straight line depreciation are the same as those used under the depreciation method you actually used. Filing 1040nr ez If you did not use a useful life under the depreciation method actually used (such as with the units-of-production method) or if you did not take salvage value into account (such as with the declining balance method), the useful life or salvage value for figuring what would have been the straight line depreciation is the useful life and salvage value you would have used under the straight line method. Filing 1040nr ez   Salvage value and useful life are not used for the ACRS method of depreciation. Filing 1040nr ez Figure straight line depreciation for ACRS real property by using its 15-, 18-, or 19-year recovery period as the property's useful life. Filing 1040nr ez   The straight line method is applied without any basis reduction for the investment credit. Filing 1040nr ez Property held by lessee. Filing 1040nr ez   If a lessee makes a leasehold improvement, the lease period for figuring what would have been the straight line depreciation adjustments includes all renewal periods. Filing 1040nr ez This inclusion of the renewal periods cannot extend the lease period taken into account to a period that is longer than the remaining useful life of the improvement. Filing 1040nr ez The same rule applies to the cost of acquiring a lease. Filing 1040nr ez   The term renewal period means any period for which the lease may be renewed, extended, or continued under an option exercisable by the lessee. Filing 1040nr ez However, the inclusion of renewal periods cannot extend the lease by more than two-thirds of the period that was the basis on which the actual depreciation adjustments were allowed. Filing 1040nr ez Applicable Percentage The applicable percentage used to figure the ordinary income because of additional depreciation depends on whether the real property you disposed of is nonresidential real property, residential rental property, or low-income housing. Filing 1040nr ez The percentages for these types of real property are as follows. Filing 1040nr ez Nonresidential real property. Filing 1040nr ez   For real property that is not residential rental property, the applicable percentage for periods after 1969 is 100%. Filing 1040nr ez For periods before 1970, the percentage is zero and no ordinary income because of additional depreciation before 1970 will result from its disposition. Filing 1040nr ez Residential rental property. Filing 1040nr ez   For residential rental property (80% or more of the gross income is from dwelling units) other than low-income housing, the applicable percentage for periods after 1975 is 100%. Filing 1040nr ez The percentage for periods before 1976 is zero. Filing 1040nr ez Therefore, no ordinary income because of additional depreciation before 1976 will result from a disposition of residential rental property. Filing 1040nr ez Low-income housing. Filing 1040nr ez    Low-income housing includes all the following types of residential rental property. Filing 1040nr ez Federally assisted housing projects if the mortgage is insured under section 221(d)(3) or 236 of the National Housing Act or housing financed or assisted by direct loan or tax abatement under similar provisions of state or local laws. Filing 1040nr ez Low-income rental housing for which a depreciation deduction for rehabilitation expenses was allowed. Filing 1040nr ez Low-income rental housing held for occupancy by families or individuals eligible to receive subsidies under section 8 of the United States Housing Act of 1937, as amended, or under provisions of state or local laws that authorize similar subsidies for low-income families. Filing 1040nr ez Housing financed or assisted by direct loan or insured under Title V of the Housing Act of 1949. Filing 1040nr ez   The applicable percentage for low-income housing is 100% minus 1% for each full month the property was held over 100 full months. Filing 1040nr ez If you have held low-income housing at least 16 years and 8 months, the percentage is zero and no ordinary income will result from its disposition. Filing 1040nr ez Foreclosure. Filing 1040nr ez   If low-income housing is disposed of because of foreclosure or similar proceedings, the monthly applicable percentage reduction is figured as if you disposed of the property on the starting date of the proceedings. Filing 1040nr ez Example. Filing 1040nr ez On June 1, 2001, you acquired low-income housing property. Filing 1040nr ez On April 3, 2012 (130 months after the property was acquired), foreclosure proceedings were started on the property and on December 3, 2013 (150 months after the property was acquired), the property was disposed of as a result of the foreclosure proceedings. Filing 1040nr ez The property qualifies for a reduced applicable percentage because it was held more than 100 full months. Filing 1040nr ez The applicable percentage reduction is 30% (130 months minus 100 months) rather than 50% (150 months minus 100 months) because it does not apply after April 3, 2012, the starting date of the foreclosure proceedings. Filing 1040nr ez Therefore, 70% of the additional depreciation is treated as ordinary income. Filing 1040nr ez Holding period. Filing 1040nr ez   The holding period used to figure the applicable percentage for low-income housing generally starts on the day after you acquired it. Filing 1040nr ez For example, if you bought low-income housing on January 1, 1997, the holding period starts on January 2, 1997. Filing 1040nr ez If you sold it on January 2, 2013, the holding period is exactly 192 full months. Filing 1040nr ez The applicable percentage for additional depreciation is 8%, or 100% minus 1% for each full month the property was held over 100 full months. Filing 1040nr ez Holding period for constructed, reconstructed, or erected property. Filing 1040nr ez   The holding period used to figure the applicable percentage for low-income housing you constructed, reconstructed, or erected starts on the first day of the month it is placed in service in a trade or business, in an activity for the production of income, or in a personal activity. Filing 1040nr ez Property acquired by gift or received in a tax-free transfer. Filing 1040nr ez   For low-income housing you acquired by gift or in a tax-free transfer the basis of which is figured by reference to the basis in the hands of the transferor, the holding period for the applicable percentage includes the holding period of the transferor. Filing 1040nr ez   If the adjusted basis of the property in your hands just after acquiring it is more than its adjusted basis to the transferor just before transferring it, the holding period of the difference is figured as if it were a separate improvement. Filing 1040nr ez See Low-Income Housing With Two or More Elements, next. Filing 1040nr ez Low-Income Housing With Two or More Elements If you dispose of low-income housing property that has two or more separate elements, the applicable percentage used to figure ordinary income because of additional depreciation may be different for each element. Filing 1040nr ez The gain to be reported as ordinary income is the sum of the ordinary income figured for each element. Filing 1040nr ez The following are the types of separate elements. Filing 1040nr ez A separate improvement (defined below). Filing 1040nr ez The basic section 1250 property plus improvements not qualifying as separate improvements. Filing 1040nr ez The units placed in service at different times before all the section 1250 property is finished. Filing 1040nr ez For example, this happens when a taxpayer builds an apartment building of 100 units and places 30 units in service (available for renting) on January 4, 2011, 50 on July 18, 2011, and the remaining 20 on January 18, 2012. Filing 1040nr ez As a result, the apartment house consists of three separate elements. Filing 1040nr ez The 36-month test for separate improvements. Filing 1040nr ez   A separate improvement is any improvement (qualifying under The 1-year test, below) added to the capital account of the property, but only if the total of the improvements during the 36-month period ending on the last day of any tax year is more than the greatest of the following amounts. Filing 1040nr ez Twenty-five percent of the adjusted basis of the property at the start of the first day of the 36-month period, or the first day of the holding period of the property, whichever is later. Filing 1040nr ez Ten percent of the unadjusted basis (adjusted basis plus depreciation and amortization adjustments) of the property at the start of the period determined in (1). Filing 1040nr ez $5,000. Filing 1040nr ez The 1-year test. Filing 1040nr ez   An addition to the capital account for any tax year (including a short tax year) is treated as an improvement only if the sum of all additions for the year is more than the greater of $2,000 or 1% of the unadjusted basis of the property. Filing 1040nr ez The unadjusted basis is figured as of the start of that tax year or the holding period of the property, whichever is later. Filing 1040nr ez In applying the 36-month test, improvements in any one of the 3 years are omitted entirely if the total improvements in that year do not qualify under the 1-year test. Filing 1040nr ez Example. Filing 1040nr ez The unadjusted basis of a calendar year taxpayer's property was $300,000 on January 1 of this year. Filing 1040nr ez During the year, the taxpayer made improvements A, B, and C, which cost $1,000, $600, and $700, respectively. Filing 1040nr ez The sum of the improvements, $2,300, is less than 1% of the unadjusted basis ($3,000), so the improvements do not satisfy the 1-year test and are not treated as improvements for the 36-month test. Filing 1040nr ez However, if improvement C had cost $1,500, the sum of these improvements would have been $3,100. Filing 1040nr ez Then, it would be necessary to apply the 36-month test to figure if the improvements must be treated as separate improvements. Filing 1040nr ez Addition to the capital account. Filing 1040nr ez   Any addition to the capital account made after the initial acquisition or completion of the property by you or any person who held the property during a period included in your holding period is to be considered when figuring the total amount of separate improvements. Filing 1040nr ez   The addition to the capital account of depreciable real property is the gross addition not reduced by amounts attributable to replaced property. Filing 1040nr ez For example, if a roof with an adjusted basis of $20,000 is replaced by a new roof costing $50,000, the improvement is the gross addition to the account, $50,000, and not the net addition of $30,000. Filing 1040nr ez The $20,000 adjusted basis of the old roof is no longer reflected in the basis of the property. Filing 1040nr ez The status of an addition to the capital account is not affected by whether it is treated as a separate property for determining depreciation deductions. Filing 1040nr ez   Whether an expense is treated as an addition to the capital account may depend on the final disposition of the entire property. Filing 1040nr ez If the expense item property and the basic property are sold in two separate transactions, the entire section 1250 property is treated as consisting of two distinct properties. Filing 1040nr ez Unadjusted basis. Filing 1040nr ez   In figuring the unadjusted basis as of a certain date, include the actual cost of all previous additions to the capital account plus those that did not qualify as separate improvements. Filing 1040nr ez However, the cost of components retired before that date is not included in the unadjusted basis. Filing 1040nr ez Holding period. Filing 1040nr ez   Use the following guidelines for figuring the applicable percentage for property with two or more elements. Filing 1040nr ez The holding period of a separate element placed in service before the entire section 1250 property is finished starts on the first day of the month that the separate element is placed in service. Filing 1040nr ez The holding period for each separate improvement qualifying as a separate element starts on the day after the improvement is acquired or, for improvements constructed, reconstructed, or erected, the first day of the month that the improvement is placed in service. Filing 1040nr ez The holding period for each improvement not qualifying as a separate element takes the holding period of the basic property. Filing 1040nr ez   If an improvement by itself does not meet the 1-year test (greater of $2,000 or 1% of the unadjusted basis), but it does qualify as a separate improvement that is a separate element (when grouped with other improvements made during the tax year), determine the start of its holding period as follows. Filing 1040nr ez Use the first day of a calendar month that is closest to the middle of the tax year. Filing 1040nr ez If there are two first days of a month that are equally close to the middle of the year, use the earlier date. Filing 1040nr ez Figuring ordinary income attributable to each separate element. Filing 1040nr ez   Figure ordinary income attributable to each separate element as follows. Filing 1040nr ez   Step 1. Filing 1040nr ez Divide the element's additional depreciation after 1975 by the sum of all the elements' additional depreciation after 1975 to determine the percentage used in Step 2. Filing 1040nr ez   Step 2. Filing 1040nr ez Multiply the percentage figured in Step 1 by the lesser of the additional depreciation after 1975 for the entire property or the gain from disposition of the entire property (the difference between the fair market value or amount realized and the adjusted basis). Filing 1040nr ez   Step 3. Filing 1040nr ez Multiply the result in Step 2 by the applicable percentage for the element. Filing 1040nr ez Example. Filing 1040nr ez You sold at a gain of $25,000 low-income housing property subject to the ordinary income rules of section 1250. Filing 1040nr ez The property consisted of four elements (W, X, Y, and Z). Filing 1040nr ez Step 1. Filing 1040nr ez The additional depreciation for each element is: W-$12,000; X-None; Y-$6,000; and Z-$6,000. Filing 1040nr ez The sum of the additional depreciation for all the elements is $24,000. Filing 1040nr ez Step 2. Filing 1040nr ez The depreciation deducted on element X was $4,000 less than it would have been under the straight line method. Filing 1040nr ez Additional depreciation on the property as a whole is $20,000 ($24,000 − $4,000). Filing 1040nr ez $20,000 is lower than the $25,000 gain on the sale, so $20,000 is used in Step 2. Filing 1040nr ez Step 3. Filing 1040nr ez The applicable percentages to be used in Step 3 for the elements are: W-68%; X-85%; Y-92%; and Z-100%. Filing 1040nr ez From these facts, the sum of the ordinary income for each element is figured as follows. Filing 1040nr ez   Step 1 Step 2 Step 3 Ordinary Income W . Filing 1040nr ez 50 $10,000 68% $ 6,800 X -0- -0- 85% -0- Y . Filing 1040nr ez 25 5,000 92% 4,600 Z . Filing 1040nr ez 25 5,000 100% 5,000 Sum of ordinary income of separate elements $16,400 Gain Treated as Ordinary Income To find what part of the gain from the disposition of section 1250 property is treated as ordinary income, follow these steps. Filing 1040nr ez In a sale, exchange, or involuntary conversion of the property, figure the amount realized that is more than the adjusted basis of the property. Filing 1040nr ez In any other disposition of the property, figure the fair market value that is more than the adjusted basis. Filing 1040nr ez Figure the additional depreciation for the periods after 1975. Filing 1040nr ez Multiply the lesser of (1) or (2) by the applicable percentage, discussed earlier under Applicable Percentage. Filing 1040nr ez Stop here if this is residential rental property or if (2) is equal to or more than (1). Filing 1040nr ez This is the gain treated as ordinary income because of additional depreciation. Filing 1040nr ez Subtract (2) from (1). Filing 1040nr ez Figure the additional depreciation for periods after 1969 but before 1976. Filing 1040nr ez Add the lesser of (4) or (5) to the result in (3). Filing 1040nr ez This is the gain treated as ordinary income because of additional depreciation. Filing 1040nr ez A limit on the amount treated as ordinary income for gain on like-kind exchanges and involuntary conversions is explained later. Filing 1040nr ez Use Form 4797, Part III, to figure the ordinary income part of the gain. Filing 1040nr ez Corporations. Filing 1040nr ez   Corporations, other than S corporations, must recognize an additional amount as ordinary income on the sale or other disposition of section 1250 property. Filing 1040nr ez The additional amount treated as ordinary income is 20% of the excess of the amount that would have been ordinary income if the property were section 1245 property over the amount treated as ordinary income under section 1250. Filing 1040nr ez Report this additional ordinary income on Form 4797, Part III, line 26 (f). Filing 1040nr ez Installment Sales If you report the sale of property under the installment method, any depreciation recapture under section 1245 or 1250 is taxable as ordinary income in the year of sale. Filing 1040nr ez This applies even if no payments are received in that year. Filing 1040nr ez If the gain is more than the depreciation recapture income, report the rest of the gain using the rules of the installment method. Filing 1040nr ez For this purpose, include the recapture income in your installment sale basis to determine your gross profit on the installment sale. Filing 1040nr ez If you dispose of more than one asset in a single transaction, you must figure the gain on each asset separately so that it may be properly reported. Filing 1040nr ez To do this, allocate the selling price and the payments you receive in the year of sale to each asset. Filing 1040nr ez Report any depreciation recapture income in the year of sale before using the installment method for any remaining gain. Filing 1040nr ez For a detailed discussion of installment sales, see Publication 537. Filing 1040nr ez Gifts If you make a gift of depreciable personal property or real property, you do not have to report income on the transaction. Filing 1040nr ez However, if the person who receives it (donee) sells or otherwise disposes of the property in a disposition subject to recapture, the donee must take into account the depreciation you deducted in figuring the gain to be reported as ordinary income. Filing 1040nr ez For low-income housing, the donee must take into account the donor's holding period to figure the applicable percentage. Filing 1040nr ez See Applicable Percentage and its discussion Holding period under Section 1250 Property, earlier. Filing 1040nr ez Part gift and part sale or exchange. Filing 1040nr ez   If you transfer depreciable personal property or real property for less than its fair market value in a transaction considered to be partly a gift and partly a sale or exchange and you have a gain because the amount realized is more than your adjusted basis, you must report ordinary income (up to the amount of gain) to recapture depreciation. Filing 1040nr ez If the depreciation (additional depreciation, if section 1250 property) is more than the gain, the balance is carried over to the transferee to be taken into account on any later disposition of the property. Filing 1040nr ez However, see Bargain sale to charity, later. Filing 1040nr ez Example. Filing 1040nr ez You transferred depreciable personal property to your son for $20,000. Filing 1040nr ez When transferred, the property had an adjusted basis to you of $10,000 and a fair market value of $40,000. Filing 1040nr ez You took depreciation of $30,000. Filing 1040nr ez You are considered to have made a gift of $20,000, the difference between the $40,000 fair market value and the $20,000 sale price to your son. Filing 1040nr ez You have a taxable gain on the transfer of $10,000 ($20,000 sale price minus $10,000 adjusted basis) that must be reported as ordinary income from depreciation. Filing 1040nr ez You report $10,000 of your $30,000 depreciation as ordinary income on the transfer of the property, so the remaining $20,000 depreciation is carried over to your son for him to take into account on any later disposition of the property. Filing 1040nr ez Gift to charitable organization. Filing 1040nr ez   If you give property to a charitable organization, you figure your deduction for your charitable contribution by reducing the fair market value of the property by the ordinary income and short-term capital gain that would have resulted had you sold the property at its fair market value at the time of the contribution. Filing 1040nr ez Thus, your deduction for depreciable real or personal property given to a charitable organization does not include the potential ordinary gain from depreciation. Filing 1040nr ez   You also may have to reduce the fair market value of the contributed property by the long-term capital gain (including any section 1231 gain) that would have resulted had the property been sold. Filing 1040nr ez For more information, see Giving Property That Has Increased in Value in Publication 526. Filing 1040nr ez Bargain sale to charity. Filing 1040nr ez   If you transfer section 1245 or section 1250 property to a charitable organization for less than its fair market value and a deduction for the contribution part of the transfer is allowable, your ordinary income from depreciation is figured under different rules. Filing 1040nr ez First, figure the ordinary income as if you had sold the property at its fair market value. Filing 1040nr ez Then, allocate that amount between the sale and the contribution parts of the transfer in the same proportion that you allocated your adjusted basis in the property to figure your gain. Filing 1040nr ez See Bargain Sale under Gain or Loss From Sales and Exchanges in chapter 1. Filing 1040nr ez Report as ordinary income the lesser of the ordinary income allocated to the sale or your gain from the sale. Filing 1040nr ez Example. Filing 1040nr ez You sold section 1245 property in a bargain sale to a charitable organization and are allowed a deduction for your contribution. Filing 1040nr ez Your gain on the sale was $1,200, figured by allocating 20% of your adjusted basis in the property to the part sold. Filing 1040nr ez If you had sold the property at its fair market value, your ordinary income would have been $5,000. Filing 1040nr ez Your ordinary income is $1,000 ($5,000 × 20%) and your section 1231 gain is $200 ($1,200 – $1,000). Filing 1040nr ez Transfers at Death When a taxpayer dies, no gain is reported on depreciable personal property or real property transferred to his or her estate or beneficiary. Filing 1040nr ez For information on the tax liability of a decedent, see Publication 559, Survivors, Executors, and Administrators. Filing 1040nr ez However, if the decedent disposed of the property while alive and, because of his or her method of accounting or for any other reason, the gain from the disposition is reportable by the estate or beneficiary, it must be reported in the same way the decedent would have had to report it if he or she were still alive. Filing 1040nr ez Ordinary income due to depreciation must be reported on a transfer from an executor, administrator, or trustee to an heir, beneficiary, or other individual if the transfer is a sale or exchange on which gain is realized. Filing 1040nr ez Example 1. Filing 1040nr ez Janet Smith owned depreciable property that, upon her death, was inherited by her son. Filing 1040nr ez No ordinary income from depreciation is reportable on the transfer, even though the value used for estate tax purposes is more than the adjusted basis of the property to Janet when she died. Filing 1040nr ez However, if she sold the property before her death and realized a gain and if, because of her method of accounting, the proceeds from the sale are income in respect of a decedent reportable by her son, he must report ordinary income from depreciation. Filing 1040nr ez Example 2. Filing 1040nr ez The trustee of a trust created by a will transfers depreciable property to a beneficiary in satisfaction of a specific bequest of $10,000. Filing 1040nr ez If the property had a value of $9,000 at the date used for estate tax valuation purposes, the $1,000 increase in value to the date of distribution is a gain realized by the trust. Filing 1040nr ez Ordinary income from depreciation must be reported by the trust on the transfer. Filing 1040nr ez Like-Kind Exchanges and Involuntary Conversions A like-kind exchange of your depreciable property or an involuntary conversion of the property into similar or related property will not result in your having to report ordinary income from depreciation unless money or property other than like-kind, similar, or related property is also received in the transaction. Filing 1040nr ez For information on like-kind exchanges and involuntary conversions, see chapter 1. Filing 1040nr ez Depreciable personal property. Filing 1040nr ez   If you have a gain from either a like-kind exchange or an involuntary conversion of your depreciable personal property, the amount to be reported as ordinary income from depreciation is the amount figured under the rules explained earlier (see Section 1245 Property), limited to the sum of the following amounts. Filing 1040nr ez The gain that must be included in income under the rules for like-kind exchanges or involuntary conversions. Filing 1040nr ez The fair market value of the like-kind, similar, or related property other than depreciable personal property acquired in the transaction. Filing 1040nr ez Example 1. Filing 1040nr ez You bought a new machine for $4,300 cash plus your old machine for which you were allowed a $1,360 trade-in. Filing 1040nr ez The old machine cost you $5,000 two years ago. Filing 1040nr ez You took depreciation deductions of $3,950. Filing 1040nr ez Even though you deducted depreciation of $3,950, the $310 gain ($1,360 trade-in allowance minus $1,050 adjusted basis) is not reported because it is postponed under the rules for like-kind exchanges and you received only depreciable personal property in the exchange. Filing 1040nr ez Example 2. Filing 1040nr ez You bought office machinery for $1,500 two years ago and deducted $780 depreciation. Filing 1040nr ez This year a fire destroyed the machinery and you received $1,200 from your fire insurance, realizing a gain of $480 ($1,200 − $720 adjusted basis). Filing 1040nr ez You choose to postpone reporting gain, but replacement machinery cost you only $1,000. Filing 1040nr ez Your taxable gain under the rules for involuntary conversions is limited to the remaining $200 insurance payment. Filing 1040nr ez All your replacement property is depreciable personal property, so your ordinary income from depreciation is limited to $200. Filing 1040nr ez Example 3. Filing 1040nr ez A fire destroyed office machinery you bought for $116,000. Filing 1040nr ez The depreciation deductions were $91,640 and the machinery had an adjusted basis of $24,360. Filing 1040nr ez You received a $117,000 insurance payment, realizing a gain of $92,640. Filing 1040nr ez You immediately spent $105,000 of the insurance payment for replacement machinery and $9,000 for stock that qualifies as replacement property and you choose to postpone reporting the gain. Filing 1040nr ez $114,000 of the $117,000 insurance payment was used to buy replacement property, so the gain that must be included in income under the rules for involuntary conversions is the part not spent, or $3,000. Filing 1040nr ez The part of the insurance payment ($9,000) used to buy the nondepreciable property (the stock) also must be included in figuring the gain from depreciation. Filing 1040nr ez The amount you must report as ordinary income on the transaction is $12,000, figured as follows. Filing 1040nr ez 1) Gain realized on the transaction ($92,640) limited to depreciation ($91,640) $91,640 2) Gain includible in income (amount not spent) 3,000     Plus: fair market value of property other than depreciable personal property (the stock) 9,000 12,000 Amount reportable as ordinary income (lesser of (1) or (2)) $12,000   If, instead of buying $9,000 in stock, you bought $9,000 worth of depreciable personal property similar or related in use to the destroyed property, you would only report $3,000 as ordinary income. Filing 1040nr ez Depreciable real property. Filing 1040nr ez   If you have a gain from either a like-kind exchange or involuntary conversion of your depreciable real property, ordinary income from additional depreciation is figured under the rules explained earlier (see Section 1250 Property), limited to the greater of the following amounts. Filing 1040nr ez The gain that must be reported under the rules for like-kind exchanges or involuntary conversions plus the fair market value of stock bought as replacement property in acquiring control of a corporation. Filing 1040nr ez The gain you would have had to report as ordinary income from additional depreciation had the transaction been a cash sale minus the cost (or fair market value in an exchange) of the depreciable real property acquired. Filing 1040nr ez   The ordinary income not reported for the year of the disposition is carried over to the depreciable real property acquired in the like-kind exchange or involuntary conversion as additional depreciation from the property disposed of. Filing 1040nr ez Further, to figure the applicable percentage of additional depreciation to be treated as ordinary income, the holding period starts over for the new property. Filing 1040nr ez Example. Filing 1040nr ez The state paid you $116,000 when it condemned your depreciable real property for public use. Filing 1040nr ez You bought other real property similar in use to the property condemned for $110,000 ($15,000 for depreciable real property and $95,000 for land). Filing 1040nr ez You also bought stock for $5,000 to get control of a corporation owning property similar in use to the property condemned. Filing 1040nr ez You choose to postpone reporting the gain. Filing 1040nr ez If the transaction had been a sale for cash only, under the rules described earlier, $20,000 would have been reportable as ordinary income because of additional depreciation. Filing 1040nr ez The ordinary income to be reported is $6,000, which is the greater of the following amounts. Filing 1040nr ez The gain that must be reported under the rules for involuntary conversions, $1,000 ($116,000 − $115,000) plus the fair market value of stock bought as qualified replacement property, $5,000, for a total of $6,000. Filing 1040nr ez The gain you would have had to report as ordinary income from additional depreciation ($20,000) had this transaction been a cash sale minus the cost of the depreciable real property bought ($15,000), or $5,000. Filing 1040nr ez   The ordinary income not reported, $14,000 ($20,000 − $6,000), is carried over to the depreciable real property you bought as additional depreciation. Filing 1040nr ez Basis of property acquired. Filing 1040nr ez   If the ordinary income you have to report because of additional depreciation is limited, the total basis of the property you acquired is its fair market value (its cost, if bought to replace property involuntarily converted into money) minus the gain postponed. Filing 1040nr ez   If you acquired more than one item of property, allocate the total basis among the properties in proportion to their fair market value (their cost, in an involuntary conversion into money). Filing 1040nr ez However, if you acquired both depreciable real property and other property, allocate the total basis as follows. Filing 1040nr ez Subtract the ordinary income because of additional depreciation that you do not have to report from the fair market value (or cost) of the depreciable real property acquired. Filing 1040nr ez Add the fair market value (or cost) of the other property acquired to the result in (1). Filing 1040nr ez Divide the result in (1) by the result in (2). Filing 1040nr ez Multiply the total basis by the result in (3). Filing 1040nr ez This is the basis of the depreciable real property acquired. Filing 1040nr ez If you acquired more than one item of depreciable real property, allocate this basis amount among the properties in proportion to their fair market value (or cost). Filing 1040nr ez Subtract the result in (4) from the total basis. Filing 1040nr ez This is the basis of the other property acquired. Filing 1040nr ez If you acquired more than one item of other property, allocate this basis amount among the properties in proportion to their fair market value (or cost). Filing 1040nr ez Example 1. Filing 1040nr ez In 1988, low-income housing property that you acquired and placed in service in 1983 was destroyed by fire and you received a $90,000 insurance payment. Filing 1040nr ez The property's adjusted basis was $38,400, with additional depreciation of $14,932. Filing 1040nr ez On December 1, 1988, you used the insurance payment to acquire and place in service replacement low-income housing property. Filing 1040nr ez Your realized gain from the involuntary conversion was $51,600 ($90,000 − $38,400). Filing 1040nr ez You chose to postpone reporting the gain under the involuntary conversion rules. Filing 1040nr ez Under the rules for depreciation recapture on real property, the ordinary gain was $14,932, but you did not have to report any of it because of the limit for involuntary conversions. Filing 1040nr ez The basis of the replacement low-income housing property was its $90,000 cost minus the $51,600 gain you postponed, or $38,400. Filing 1040nr ez The $14,932 ordinary gain you did not report is treated as additional depreciation on the replacement property. Filing 1040nr ez If you sold the property in 2013, your holding period for figuring the applicable percentage of additional depreciation to report as ordinary income will have begun December 2, 1988, the day after you acquired the property. Filing 1040nr ez Example 2. Filing 1040nr ez John Adams received a $90,000 fire insurance payment for depreciable real property (office building) with an adjusted basis of $30,000. Filing 1040nr ez He uses the whole payment to buy property similar in use, spending $42,000 for depreciable real property and $48,000 for land. Filing 1040nr ez He chooses to postpone reporting the $60,000 gain realized on the involuntary conversion. Filing 1040nr ez Of this gain, $10,000 is ordinary income from additional depreciation but is not reported because of the limit for involuntary conversions of depreciable real property. Filing 1040nr ez The basis of the property bought is $30,000 ($90,000 − $60,000), allocated as follows. Filing 1040nr ez The $42,000 cost of depreciable real property minus $10,000 ordinary income not reported is $32,000. Filing 1040nr ez The $48,000 cost of other property (land) plus the $32,000 figured in (1) is $80,000. Filing 1040nr ez The $32,000 figured in (1) divided by the $80,000 figured in (2) is 0. Filing 1040nr ez 4. Filing 1040nr ez The basis of the depreciable real property is $12,000. Filing 1040nr ez This is the $30,000 total basis multiplied by the 0. Filing 1040nr ez 4 figured in (3). Filing 1040nr ez The basis of the other property (land) is $18,000. Filing 1040nr ez This is the $30,000 total basis minus the $12,000 figured in (4). Filing 1040nr ez The ordinary income that is not reported ($10,000) is carried over as additional depreciation to the depreciable real property that was bought and may be taxed as ordinary income on a later disposition. Filing 1040nr ez Multiple Properties If you dispose of depreciable property and other property in one transaction and realize a gain, you must allocate the amount realized between the two types of property in proportion to their respective fair market values to figure the part of your gain to be reported as ordinary income from depreciation. Filing 1040nr ez Different rules may apply to the allocation of the amount realized on the sale of a business that includes a group of assets. Filing 1040nr ez See chapter 2. Filing 1040nr ez In general, if a buyer and seller have adverse interests as to the allocation of the amount realized between the depreciable property and other property, any arm's length agreement between them will establish the allocation. Filing 1040nr ez In the absence of an agreement, the allocation should be made by taking into account the appropriate facts and circumstances. Filing 1040nr ez These include, but are not limited to, a comparison between the depreciable property and all the other property being disposed of in the transaction. Filing 1040nr ez The comparison should take into account all the following facts and circumstances. Filing 1040nr ez The original cost and reproduction cost of construction, erection, or production. Filing 1040nr ez The remaining economic useful life. Filing 1040nr ez The state of obsolescence. Filing 1040nr ez The anticipated expenditures required to maintain, renovate, or modernize the properties. Filing 1040nr ez Like-kind exchanges and involuntary conversions. Filing 1040nr ez   If you dispose of and acquire depreciable personal property and other property (other than depreciable real property) in a like-kind exchange or involuntary conversion, the amount realized is allocated in the following way. Filing 1040nr ez The amount allocated to the depreciable personal property disposed of is treated as consisting of, first, the fair market value of the depreciable personal property acquired and, second (to the extent of any remaining balance), the fair market value of the other property acquired. Filing 1040nr ez The amount allocated to the other property disposed of is treated as consisting of the fair market value of all property acquired that has not already been taken into account. Filing 1040nr ez   If you dispose of and acquire depreciable real property and other property in a like-kind exchange or involuntary conversion, the amount realized is allocated in the following way. Filing 1040nr ez The amount allocated to each of the three types of property (depreciable real property, depreciable personal property, or other property) disposed of is treated as consisting of, first, the fair market value of that type of property acquired and, second (to the extent of any remaining balance), any excess fair market value of the other types of property acquired. Filing 1040nr ez If the excess fair market value is more than the remaining balance of the amount realized and is from both of the other two types of property, you can apply the unallocated amount in any manner you choose. Filing 1040nr ez Example. Filing 1040nr ez A fire destroyed your property with a total fair market value of $50,000. Filing 1040nr ez It consisted of machinery worth $30,000 and nondepreciable property worth $20,000. Filing 1040nr ez You received an insurance payment of $40,000 and immediately used it with $10,000 of your own funds (for a total of $50,000) to buy machinery with a fair market value of $15,000 and nondepreciable property with a fair market value of $35,000. Filing 1040nr ez The adjusted basis of the destroyed machinery was $5,000 and your depreciation on it was $35,000. Filing 1040nr ez You choose to postpone reporting your gain from the involuntary conversion. Filing 1040nr ez You must report $9,000 as ordinary income from depreciation arising from this transaction, figured as follows. Filing 1040nr ez The $40,000 insurance payment must be allocated between the machinery and the other property destroyed in proportion to the fair market value of each. Filing 1040nr ez The amount allocated to the machinery is 30,000/50,000 × $40,000, or $24,000. Filing 1040nr ez The amount allocated to the other property is 20,000/50,000 × $40,000, or $16,000. Filing 1040nr ez Your gain on the involuntary conversion of the machinery is $24,000 minus $5,000 adjusted basis, or $19,000. Filing 1040nr ez The $24,000 allocated to the machinery disposed of is treated as consisting of the $15,000 fair market value of the replacement machinery bought and $9,000 of the fair market value of other property bought in the transaction. Filing 1040nr ez All $16,000 allocated to the other property disposed of is treated as consisting of the fair market value of the other property that was bought. Filing 1040nr ez Your potential ordinary income from depreciation is $19,000, the gain on the machinery, because it is less than the $35,000 depreciation. Filing 1040nr ez However, the amount you must report as ordinary income is limited to the $9,000 included in the amount realized for the machinery that represents the fair market value of property other than the depreciable property you bought. Filing 1040nr ez Prev  Up  Next   Home   More Online Publications
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The Filing 1040nr Ez

Filing 1040nr ez Publication 538 - Main Content Table of Contents Accounting PeriodsCalendar Year Fiscal Year Short Tax Year Improper Tax Year Change in Tax Year Individuals Partnerships, S Corporations, and Personal Service Corporations (PSCs) Corporations (Other Than S Corporations and PSCs) Accounting MethodsSpecial methods. Filing 1040nr ez Hybrid method. Filing 1040nr ez Cash Method Accrual Method Inventories Change in Accounting Method How To Get Tax HelpLow Income Taxpayer Clinics (LITCs). Filing 1040nr ez Accounting Periods You must use a tax year to figure your taxable income. Filing 1040nr ez A tax year is an annual accounting period for keeping records and reporting income and expenses. Filing 1040nr ez An annual accounting period does not include a short tax year (discussed later). Filing 1040nr ez You can use the following tax years: A calendar year; or A fiscal year (including a 52-53-week tax year). Filing 1040nr ez Unless you have a required tax year, you adopt a tax year by filing your first income tax return using that tax year. Filing 1040nr ez A required tax year is a tax year required under the Internal Revenue Code or the Income Tax Regulations. Filing 1040nr ez You cannot adopt a tax year by merely: Filing an application for an extension of time to file an income tax return; Filing an application for an employer identification number (Form SS-4); or Paying estimated taxes. Filing 1040nr ez This section discusses: A calendar year. Filing 1040nr ez A fiscal year (including a period of 52 or 53 weeks). Filing 1040nr ez A short tax year. Filing 1040nr ez An improper tax year. Filing 1040nr ez A change in tax year. Filing 1040nr ez Special situations that apply to individuals. Filing 1040nr ez Restrictions that apply to the accounting period of a partnership, S corporation, or personal service corporation. Filing 1040nr ez Special situations that apply to corporations. Filing 1040nr ez Calendar Year A calendar year is 12 consecutive months beginning on January 1st and ending on December 31st. Filing 1040nr ez If you adopt the calendar year, you must maintain your books and records and report your income and expenses from January 1st through December 31st of each year. Filing 1040nr ez If you file your first tax return using the calendar tax year and you later begin business as a sole proprietor, become a partner in a partnership, or become a shareholder in an S corporation, you must continue to use the calendar year unless you obtain approval from the IRS to change it, or are otherwise allowed to change it without IRS approval. Filing 1040nr ez See Change in Tax Year, later. Filing 1040nr ez Generally, anyone can adopt the calendar year. Filing 1040nr ez However, you must adopt the calendar year if: You keep no books or records; You have no annual accounting period; Your present tax year does not qualify as a fiscal year; or You are required to use a calendar year by a provision in the Internal Revenue Code or the Income Tax Regulations. Filing 1040nr ez Fiscal Year A fiscal year is 12 consecutive months ending on the last day of any month except December 31st. Filing 1040nr ez If you are allowed to adopt a fiscal year, you must consistently maintain your books and records and report your income and expenses using the time period adopted. Filing 1040nr ez 52-53-Week Tax Year You can elect to use a 52-53-week tax year if you keep your books and records and report your income and expenses on that basis. Filing 1040nr ez If you make this election, your 52-53-week tax year must always end on the same day of the week. Filing 1040nr ez Your 52-53-week tax year must always end on: Whatever date this same day of the week last occurs in a calendar month, or Whatever date this same day of the week falls that is nearest to the last day of the calendar month. Filing 1040nr ez For example, if you elect a tax year that always ends on the last Monday in March, your 2012 tax year will end on March 25, 2013. Filing 1040nr ez Election. Filing 1040nr ez   To make the election for the 52-53-week tax year, attach a statement with the following information to your tax return. Filing 1040nr ez The month in which the new 52-53-week tax year ends. Filing 1040nr ez The day of the week on which the tax year always ends. Filing 1040nr ez The date the tax year ends. Filing 1040nr ez It can be either of the following dates on which the chosen day: Last occurs in the month in (1), above, or Occurs nearest to the last day of the month in (1), above. Filing 1040nr ez   When you figure depreciation or amortization, a 52-53-week tax year is generally considered a year of 12 calendar months. Filing 1040nr ez   To determine an effective date (or apply provisions of any law) expressed in terms of tax years beginning, including, or ending on the first or last day of a specified calendar month, a 52-53-week tax year is considered to: Begin on the first day of the calendar month beginning nearest to the first day of the 52-53-week tax year, and End on the last day of the calendar month ending nearest to the last day of the 52-53-week tax year. Filing 1040nr ez Example. Filing 1040nr ez Assume a tax provision applies to tax years beginning on or after July 1, 2012, which happens to be a Sunday. Filing 1040nr ez For this purpose, a 52-53-week tax year that begins on the last Tuesday of June, which falls on June 26, 2012, is treated as beginning on July 1, 2012. Filing 1040nr ez Short Tax Year A short tax year is a tax year of less than 12 months. Filing 1040nr ez A short period tax return may be required when you (as a taxable entity): Are not in existence for an entire tax year, or Change your accounting period. Filing 1040nr ez Tax on a short period tax return is figured differently for each situation. Filing 1040nr ez Not in Existence Entire Year Even if a taxable entity was not in existence for the entire year, a tax return is required for the time it was in existence. Filing 1040nr ez Requirements for filing the return and figuring the tax are generally the same as the requirements for a return for a full tax year (12 months) ending on the last day of the short tax year. Filing 1040nr ez Example 1. Filing 1040nr ez XYZ Corporation was organized on July 1, 2012. Filing 1040nr ez It elected the calendar year as its tax year. Filing 1040nr ez Therefore, its first tax return was due March 15, 2013. Filing 1040nr ez This short period return will cover the period from July 1, 2012, through December 31, 2012. Filing 1040nr ez Example 2. Filing 1040nr ez A calendar year corporation dissolved on July 23, 2012. Filing 1040nr ez Its final return is due by October 15, 2012. Filing 1040nr ez It will cover the short period from January 1, 2012, through July 23, 2012. Filing 1040nr ez Death of individual. Filing 1040nr ez   When an individual dies, a tax return must be filed for the decedent by the 15th day of the 4th month after the close of the individual's regular tax year. Filing 1040nr ez The decedent's final return will be a short period tax return that begins on January 1st, and ends on the date of death. Filing 1040nr ez In the case of a decedent who dies on December 31st, the last day of the regular tax year, a full calendar-year tax return is required. Filing 1040nr ez Example. Filing 1040nr ez   Agnes Green was a single, calendar year taxpayer. Filing 1040nr ez She died on March 6, 2012. Filing 1040nr ez Her final income tax return must be filed by April 15, 2013. Filing 1040nr ez It will cover the short period from January 1, 2012, to March 6, 2012. Filing 1040nr ez Figuring Tax for Short Year If the IRS approves a change in your tax year or you are required to change your tax year, you must figure the tax and file your return for the short tax period. Filing 1040nr ez The short tax period begins on the first day after the close of your old tax year and ends on the day before the first day of your new tax year. Filing 1040nr ez Figure tax for a short year under the general rule, explained below. Filing 1040nr ez You may then be able to use a relief procedure, explained later, and claim a refund of part of the tax you paid. Filing 1040nr ez General rule. Filing 1040nr ez   Income tax for a short tax year must be annualized. Filing 1040nr ez However, self-employment tax is figured on the actual self-employment income for the short period. Filing 1040nr ez Individuals. Filing 1040nr ez   An individual must figure income tax for the short tax year as follows. Filing 1040nr ez Determine your adjusted gross income (AGI) for the short tax year and then subtract your actual itemized deductions for the short tax year. Filing 1040nr ez You must itemize deductions when you file a short period tax return. Filing 1040nr ez Multiply the dollar amount of your exemptions by the number of months in the short tax year and divide the result by 12. Filing 1040nr ez Subtract the amount in (2) from the amount in (1). Filing 1040nr ez The result is your modified taxable income. Filing 1040nr ez Multiply the modified taxable income in (3) by 12, then divide the result by the number of months in the short tax year. Filing 1040nr ez The result is your annualized income. Filing 1040nr ez Figure the total tax on your annualized income using the appropriate tax rate schedule. Filing 1040nr ez Multiply the total tax by the number of months in the short tax year and divide the result by 12. Filing 1040nr ez The result is your tax for the short tax year. Filing 1040nr ez Relief procedure. Filing 1040nr ez   Individuals and corporations can use a relief procedure to figure the tax for the short tax year. Filing 1040nr ez It may result in less tax. Filing 1040nr ez Under this procedure, the tax is figured by two separate methods. Filing 1040nr ez If the tax figured under both methods is less than the tax figured under the general rule, you can file a claim for a refund of part of the tax you paid. Filing 1040nr ez For more information, see section 443(b)(2) of the Internal Revenue Code. Filing 1040nr ez Alternative minimum tax. Filing 1040nr ez   To figure the alternative minimum tax (AMT) due for a short tax year: Figure the annualized alternative minimum taxable income (AMTI) for the short tax period by completing the following steps. Filing 1040nr ez Multiply the AMTI by 12. Filing 1040nr ez Divide the result by the number of months in the short tax year. Filing 1040nr ez Multiply the annualized AMTI by the appropriate rate of tax under section 55(b)(1) of the Internal Revenue Code. Filing 1040nr ez The result is the annualized AMT. Filing 1040nr ez Multiply the annualized AMT by the number of months in the short tax year and divide the result by 12. Filing 1040nr ez   For information on the AMT for individuals, see the Instructions for Form 6251, Alternative Minimum Tax–Individuals. Filing 1040nr ez For information on the AMT for corporations, see the Instructions to Form 4626, Alternative Minimum Tax–Corporations. Filing 1040nr ez Tax withheld from wages. Filing 1040nr ez   You can claim a credit against your income tax liability for federal income tax withheld from your wages. Filing 1040nr ez Federal income tax is withheld on a calendar year basis. Filing 1040nr ez The amount withheld in any calendar year is allowed as a credit for the tax year beginning in the calendar year. Filing 1040nr ez Improper Tax Year Taxpayers that have adopted an improper tax year must change to a proper tax year. Filing 1040nr ez For example, if a taxpayer began business on March 15 and adopted a tax year ending on March 14 (a period of exactly 12 months), this would be an improper tax year. Filing 1040nr ez See Accounting Periods, earlier, for a description of permissible tax years. Filing 1040nr ez To change to a proper tax year, you must do one of the following. Filing 1040nr ez If you are requesting a change to a calendar tax year, file an amended income tax return based on a calendar tax year that corrects the most recently filed tax return that was filed on the basis of an improper tax year. Filing 1040nr ez Attach a completed Form 1128 to the amended tax return. Filing 1040nr ez Write “FILED UNDER REV. Filing 1040nr ez PROC. Filing 1040nr ez 85-15” at the top of Form 1128 and file the forms with the Internal Revenue Service Center where you filed your original return. Filing 1040nr ez If you are requesting a change to a fiscal tax year, file Form 1128 in accordance with the form instructions to request IRS approval for the change. Filing 1040nr ez Change in Tax Year Generally, you must file Form 1128 to request IRS approval to change your tax year. Filing 1040nr ez See the Instructions for Form 1128 for exceptions. Filing 1040nr ez If you qualify for an automatic approval request, a user fee is not required. Filing 1040nr ez Individuals Generally, individuals must adopt the calendar year as their tax year. Filing 1040nr ez An individual can adopt a fiscal year provided that the individual maintains his or her books and records on the basis of the adopted fiscal year. Filing 1040nr ez Partnerships, S Corporations, and Personal Service Corporations (PSCs) Generally, partnerships, S corporations (including electing S corporations), and PSCs must use a required tax year. Filing 1040nr ez A required tax year is a tax year that is required under the Internal Revenue Code and Income Tax Regulations. Filing 1040nr ez The entity does not have to use the required tax year if it receives IRS approval to use another permitted tax year or makes an election under section 444 of the Internal Revenue Code (discussed later). Filing 1040nr ez The following discussions provide the rules for partnerships, S corporations, and PSCs. Filing 1040nr ez Partnership A partnership must conform its tax year to its partners' tax years unless any of the following apply. Filing 1040nr ez The partnership makes an election under section 444 of the Internal Revenue Code to have a tax year other than a required tax year by filing Form 8716. Filing 1040nr ez The partnership elects to use a 52-53-week tax year that ends with reference to either its required tax year or a tax year elected under section 444. Filing 1040nr ez The partnership can establish a business purpose for a different tax year. Filing 1040nr ez The rules for the required tax year for partnerships are as follows. Filing 1040nr ez If one or more partners having the same tax year own a majority interest (more than 50%) in partnership profits and capital, the partnership must use the tax year of those partners. Filing 1040nr ez If there is no majority interest tax year, the partnership must use the tax year of all its principal partners. Filing 1040nr ez A principal partner is one who has a 5% or more interest in the profits or capital of the partnership. Filing 1040nr ez If there is no majority interest tax year and the principal partners do not have the same tax year, the partnership generally must use a tax year that results in the least aggregate deferral of income to the partners. Filing 1040nr ez If a partnership changes to a required tax year because of these rules, it can get automatic approval by filing Form 1128. Filing 1040nr ez Least aggregate deferral of income. Filing 1040nr ez   The tax year that results in the least aggregate deferral of income is determined as follows. Filing 1040nr ez Figure the number of months of deferral for each partner using one partner's tax year. Filing 1040nr ez Find the months of deferral by counting the months from the end of that tax year forward to the end of each other partner's tax year. Filing 1040nr ez Multiply each partner's months of deferral figured in step (1) by that partner's share of interest in the partnership profits for the year used in step (1). Filing 1040nr ez Add the amounts in step (2) to get the aggregate (total) deferral for the tax year used in step (1). Filing 1040nr ez Repeat steps (1) through (3) for each partner's tax year that is different from the other partners' years. Filing 1040nr ez   The partner's tax year that results in the lowest aggregate (total) number is the tax year that must be used by the partnership. Filing 1040nr ez If the calculation results in more than one tax year qualifying as the tax year with the least aggregate deferral, the partnership can choose any one of those tax years as its tax year. Filing 1040nr ez However, if one of the tax years that qualifies is the partnership's existing tax year, the partnership must retain that tax year. Filing 1040nr ez Example. Filing 1040nr ez A and B each have a 50% interest in partnership P, which uses a fiscal year ending June 30. Filing 1040nr ez A uses the calendar year and B uses a fiscal year ending November 30. Filing 1040nr ez P must change its tax year to a fiscal year ending November 30 because this results in the least aggregate deferral of income to the partners, as shown in the following table. Filing 1040nr ez Year End 12/31: Year End Profits Interest Months of Deferral Interest × Deferral A 12/31 0. Filing 1040nr ez 5 -0- -0- B 11/30 0. Filing 1040nr ez 5 11 5. Filing 1040nr ez 5 Total Deferral 5. Filing 1040nr ez 5 Year End 11/30: Year End Profits Interest Months of Deferral Interest × Deferral A 12/31 0. Filing 1040nr ez 5 1 0. Filing 1040nr ez 5 B 11/30 0. Filing 1040nr ez 5 -0- -0- Total Deferral 0. Filing 1040nr ez 5 When determination is made. Filing 1040nr ez   The determination of the tax year under the least aggregate deferral rules must generally be made at the beginning of the partnership's current tax year. Filing 1040nr ez However, the IRS can require the partnership to use another day or period that will more accurately reflect the ownership of the partnership. Filing 1040nr ez This could occur, for example, if a partnership interest was transferred for the purpose of qualifying for a particular tax year. Filing 1040nr ez Short period return. Filing 1040nr ez   When a partnership changes its tax year, a short period return must be filed. Filing 1040nr ez The short period return covers the months between the end of the partnership's prior tax year and the beginning of its new tax year. Filing 1040nr ez   If a partnership changes to the tax year resulting in the least aggregate deferral, it must file a Form 1128 with the short period return showing the computations used to determine that tax year. Filing 1040nr ez The short period return must indicate at the top of page 1, “FILED UNDER SECTION 1. Filing 1040nr ez 706-1. Filing 1040nr ez ” More information. Filing 1040nr ez   For more information about changing a partnership's tax year, and information about ruling requests, see the Instructions for Form 1128. Filing 1040nr ez S Corporation All S corporations, regardless of when they became an S corporation, must use a permitted tax year. Filing 1040nr ez A permitted tax year is any of the following. Filing 1040nr ez The calendar year. Filing 1040nr ez A tax year elected under section 444 of the Internal Revenue Code. Filing 1040nr ez See Section 444 Election, below for details. Filing 1040nr ez A 52-53-week tax year ending with reference to the calendar year or a tax year elected under section 444. Filing 1040nr ez Any other tax year for which the corporation establishes a business purpose. Filing 1040nr ez If an electing S corporation wishes to adopt a tax year other than a calendar year, it must request IRS approval using Form 2553, instead of filing Form 1128. Filing 1040nr ez For information about changing an S corporation's tax year and information about ruling requests, see the Instructions for Form 1128. Filing 1040nr ez Personal Service Corporation (PSC) A PSC must use a calendar tax year unless any of the following apply. Filing 1040nr ez The corporation makes an election under section 444 of the Internal Revenue Code. Filing 1040nr ez See Section 444 Election, below for details. Filing 1040nr ez The corporation elects to use a 52-53-week tax year ending with reference to the calendar year or a tax year elected under section 444. Filing 1040nr ez The corporation establishes a business purpose for a fiscal year. Filing 1040nr ez See the Instructions for Form 1120 for general information about PSCs. Filing 1040nr ez For information on adopting or changing tax years for PSCs and information about ruling requests, see the Instructions for Form 1128. Filing 1040nr ez Section 444 Election A partnership, S corporation, electing S corporation, or PSC can elect under section 444 of the Internal Revenue Code to use a tax year other than its required tax year. Filing 1040nr ez Certain restrictions apply to the election. Filing 1040nr ez A partnership or an S corporation that makes a section 444 election must make certain required payments and a PSC must make certain distributions (discussed later). Filing 1040nr ez The section 444 election does not apply to any partnership, S corporation, or PSC that establishes a business purpose for a different period, explained later. Filing 1040nr ez A partnership, S corporation, or PSC can make a section 444 election if it meets all the following requirements. Filing 1040nr ez It is not a member of a tiered structure (defined in section 1. Filing 1040nr ez 444-2T of the regulations). Filing 1040nr ez It has not previously had a section 444 election in effect. Filing 1040nr ez It elects a year that meets the deferral period requirement. Filing 1040nr ez Deferral period. Filing 1040nr ez   The determination of the deferral period depends on whether the partnership, S corporation, or PSC is retaining its tax year or adopting or changing its tax year with a section 444 election. Filing 1040nr ez Retaining tax year. Filing 1040nr ez   Generally, a partnership, S corporation, or PSC can make a section 444 election to retain its tax year only if the deferral period of the new tax year is 3 months or less. Filing 1040nr ez This deferral period is the number of months between the beginning of the retained year and the close of the first required tax year. Filing 1040nr ez Adopting or changing tax year. Filing 1040nr ez   If the partnership, S corporation, or PSC is adopting or changing to a tax year other than its required year, the deferral period is the number of months from the end of the new tax year to the end of the required tax year. Filing 1040nr ez The IRS will allow a section 444 election only if the deferral period of the new tax year is less than the shorter of: Three months, or The deferral period of the tax year being changed. Filing 1040nr ez This is the tax year immediately preceding the year for which the partnership, S corporation, or PSC wishes to make the section 444 election. Filing 1040nr ez If the partnership, S corporation, or PSC's tax year is the same as its required tax year, the deferral period is zero. Filing 1040nr ez Example 1. Filing 1040nr ez BD Partnership uses a calendar year, which is also its required tax year. Filing 1040nr ez BD cannot make a section 444 election because the deferral period is zero. Filing 1040nr ez Example 2. Filing 1040nr ez E, a newly formed partnership, began operations on December 1. Filing 1040nr ez E is owned by calendar year partners. Filing 1040nr ez E wants to make a section 444 election to adopt a September 30 tax year. Filing 1040nr ez E's deferral period for the tax year beginning December 1 is 3 months, the number of months between September 30 and December 31. Filing 1040nr ez Making the election. Filing 1040nr ez   Make a section 444 election by filing Form 8716 with the Internal Revenue Service Center where the entity will file its tax return. Filing 1040nr ez Form 8716 must be filed by the earlier of: The due date (not including extensions) of the income tax return for the tax year resulting from the section 444 election, or The 15th day of the 6th month of the tax year for which the election will be effective. Filing 1040nr ez For this purpose, count the month in which the tax year begins, even if it begins after the first day of that month. Filing 1040nr ez Note. Filing 1040nr ez If the due date falls on a Saturday, Sunday, or legal holiday, file on the next business day. Filing 1040nr ez   Attach a copy of Form 8716 to Form 1065, Form 1120S, or Form 1120 for the first tax year for which the election is made. Filing 1040nr ez Example 1. Filing 1040nr ez AB, a partnership, begins operations on September 13, 2012, and is qualified to make a section 444 election to use a September 30 tax year for its tax year beginning September 13, 2012. Filing 1040nr ez AB must file Form 8716 by January 15, 2013, which is the due date of the partnership's tax return for the period from September 13, 2012, to September 30, 2012. Filing 1040nr ez Example 2. Filing 1040nr ez The facts are the same as in Example 1 except that AB begins operations on October 21, 2012. Filing 1040nr ez AB must file Form 8716 by March 17, 2013. Filing 1040nr ez Example 3. Filing 1040nr ez B is a corporation that first becomes a PSC for its tax year beginning September 1, 2012. Filing 1040nr ez B qualifies to make a section 444 election to use a September 30 tax year for its tax year beginning September 1, 2012. Filing 1040nr ez B must file Form 8716 by December 17, 2012, the due date of the income tax return for the short period from September 1, 2012, to September 30, 2012. Filing 1040nr ez Note. Filing 1040nr ez The due dates in Examples 2 and 3 are adjusted because the dates fall on a Saturday, Sunday or legal holiday. Filing 1040nr ez Extension of time for filing. Filing 1040nr ez   There is an automatic extension of 12 months to make this election. Filing 1040nr ez See the Form 8716 instructions for more information. Filing 1040nr ez Terminating the election. Filing 1040nr ez   The section 444 election remains in effect until it is terminated. Filing 1040nr ez If the election is terminated, another section 444 election cannot be made for any tax year. Filing 1040nr ez   The election ends when any of the following applies to the partnership, S corporation, or PSC. Filing 1040nr ez The entity changes to its required tax year. Filing 1040nr ez The entity liquidates. Filing 1040nr ez The entity becomes a member of a tiered structure. Filing 1040nr ez The IRS determines that the entity willfully failed to comply with the required payments or distributions. Filing 1040nr ez   The election will also end if either of the following events occur. Filing 1040nr ez An S corporation's S election is terminated. Filing 1040nr ez However, if the S corporation immediately becomes a PSC, the PSC can continue the section 444 election of the S corporation. Filing 1040nr ez A PSC ceases to be a PSC. Filing 1040nr ez If the PSC elects to be an S corporation, the S corporation can continue the election of the PSC. Filing 1040nr ez Required payment for partnership or S corporation. Filing 1040nr ez   A partnership or an S corporation must make a required payment for any tax year: The section 444 election is in effect. Filing 1040nr ez The required payment for that year (or any preceding tax year) is more than $500. Filing 1040nr ez    This payment represents the value of the tax deferral the owners receive by using a tax year different from the required tax year. Filing 1040nr ez   Form 8752, Required Payment or Refund Under Section 7519, must be filed each year the section 444 election is in effect, even if no payment is due. Filing 1040nr ez If the required payment is more than $500 (or the required payment for any prior year was more than $500), the payment must be made when Form 8752 is filed. Filing 1040nr ez If the required payment is $500 or less and no payment was required in a prior year, Form 8752 must be filed showing a zero amount. Filing 1040nr ez Applicable election year. Filing 1040nr ez   Any tax year a section 444 election is in effect, including the first year, is called an applicable election year. Filing 1040nr ez Form 8752 must be filed and the required payment made (or zero amount reported) by May 15th of the calendar year following the calendar year in which the applicable election year begins. Filing 1040nr ez Required distribution for PSC. Filing 1040nr ez   A PSC with a section 444 election in effect must distribute certain amounts to employee-owners by December 31 of each applicable year. Filing 1040nr ez If it fails to make these distributions, it may be required to defer certain deductions for amounts paid to owner-employees. Filing 1040nr ez The amount deferred is treated as paid or incurred in the following tax year. Filing 1040nr ez   For information on the minimum distribution, see the instructions for Part I of Schedule H (Form 1120), Section 280H Limitations for a Personal Service Corporation (PSC). Filing 1040nr ez Back-up election. Filing 1040nr ez   A partnership, S corporation, or PSC can file a back-up section 444 election if it requests (or plans to request) permission to use a business purpose tax year, discussed later. Filing 1040nr ez If the request is denied, the back-up section 444 election must be activated (if the partnership, S corporation, or PSC otherwise qualifies). Filing 1040nr ez Making back-up election. Filing 1040nr ez   The general rules for making a section 444 election, as discussed earlier, apply. Filing 1040nr ez When filing Form 8716, type or print “BACK-UP ELECTION” at the top of the form. Filing 1040nr ez However, if Form 8716 is filed on or after the date Form 1128 (or Form 2553) is filed, type or print “FORM 1128 (or FORM 2553) BACK-UP ELECTION” at the top of Form 8716. Filing 1040nr ez Activating election. Filing 1040nr ez   A partnership or S corporation activates its back-up election by filing the return required and making the required payment with Form 8752. Filing 1040nr ez The due date for filing Form 8752 and making the payment is the later of the following dates. Filing 1040nr ez May 15 of the calendar year following the calendar year in which the applicable election year begins. Filing 1040nr ez 60 days after the partnership or S corporation has been notified by the IRS that the business year request has been denied. Filing 1040nr ez   A PSC activates its back-up election by filing Form 8716 with its original or amended income tax return for the tax year in which the election is first effective and printing on the top of the income tax return, “ACTIVATING BACK-UP ELECTION. Filing 1040nr ez ” 52-53-Week Tax Year A partnership, S corporation, or PSC can use a tax year other than its required tax year if it elects a 52-53-week tax year (discussed earlier) that ends with reference to either its required tax year or a tax year elected under section 444 (discussed earlier). Filing 1040nr ez A newly formed partnership, S corporation, or PSC can adopt a 52-53-week tax year ending with reference to either its required tax year or a tax year elected under section 444 without IRS approval. Filing 1040nr ez However, if the entity wishes to change to a 52-53-week tax year or change from a 52-53-week tax year that references a particular month to a non-52-53-week tax year that ends on the last day of that month, it must request IRS approval by filing Form 1128. Filing 1040nr ez Business Purpose Tax Year A partnership, S corporation, or PSC establishes the business purpose for a tax year by filing Form 1128. Filing 1040nr ez See the Instructions for Form 1128 for details. Filing 1040nr ez Corporations (Other Than S Corporations and PSCs) A new corporation establishes its tax year when it files its first tax return. Filing 1040nr ez A newly reactivated corporation that has been inactive for a number of years is treated as a new taxpayer for the purpose of adopting a tax year. Filing 1040nr ez An S corporation or a PSC must use the required tax year rules, discussed earlier, to establish a tax year. Filing 1040nr ez Generally, a corporation that wants to change its tax year must obtain approval from the IRS under either the: (a) automatic approval procedures; or (b) ruling request procedures. Filing 1040nr ez See the Instructions for Form 1128 for details. Filing 1040nr ez Accounting Methods An accounting method is a set of rules used to determine when income and expenses are reported on your tax return. Filing 1040nr ez Your accounting method includes not only your overall method of accounting, but also the accounting treatment you use for any material item. Filing 1040nr ez You choose an accounting method when you file your first tax return. Filing 1040nr ez If you later want to change your accounting method, you must get IRS approval. Filing 1040nr ez See Change in Accounting Method, later. Filing 1040nr ez No single accounting method is required of all taxpayers. Filing 1040nr ez You must use a system that clearly reflects your income and expenses and you must maintain records that will enable you to file a correct return. Filing 1040nr ez In addition to your permanent accounting books, you must keep any other records necessary to support the entries on your books and tax returns. Filing 1040nr ez You must use the same accounting method from year to year. Filing 1040nr ez An accounting method clearly reflects income only if all items of gross income and expenses are treated the same from year to year. Filing 1040nr ez If you do not regularly use an accounting method that clearly reflects your income, your income will be refigured under the method that, in the opinion of the IRS, does clearly reflect income. Filing 1040nr ez Methods you can use. Filing 1040nr ez   In general, you can compute your taxable income under any of the following accounting methods. Filing 1040nr ez Cash method. Filing 1040nr ez Accrual method. Filing 1040nr ez Special methods of accounting for certain items of income and expenses. Filing 1040nr ez A hybrid method which combines elements of two or more of the above accounting methods. Filing 1040nr ez The cash and accrual methods of accounting are explained later. Filing 1040nr ez Special methods. Filing 1040nr ez   This publication does not discuss special methods of accounting for certain items of income or expenses. Filing 1040nr ez For information on reporting income using one of the long-term contract methods, see section 460 of the Internal Revenue Code and the related regulations. Filing 1040nr ez The following publications also discuss special methods of reporting income or expenses. Filing 1040nr ez Publication 225, Farmer's Tax Guide. Filing 1040nr ez Publication 535, Business Expenses. Filing 1040nr ez Publication 537, Installment Sales. Filing 1040nr ez Publication 946, How To Depreciate Property. Filing 1040nr ez Hybrid method. Filing 1040nr ez   Generally, you can use any combination of cash, accrual, and special methods of accounting if the combination clearly reflects your income and you use it consistently. Filing 1040nr ez However, the following restrictions apply. Filing 1040nr ez If an inventory is necessary to account for your income, you must use an accrual method for purchases and sales. Filing 1040nr ez See Exceptions under Inventories, later. Filing 1040nr ez Generally, you can use the cash method for all other items of income and expenses. Filing 1040nr ez See Inventories, later. Filing 1040nr ez If you use the cash method for reporting your income, you must use the cash method for reporting your expenses. Filing 1040nr ez If you use an accrual method for reporting your expenses, you must use an accrual method for figuring your income. Filing 1040nr ez Any combination that includes the cash method is treated as the cash method for purposes of section 448 of the Internal Revenue Code. Filing 1040nr ez Business and personal items. Filing 1040nr ez   You can account for business and personal items using different accounting methods. Filing 1040nr ez For example, you can determine your business income and expenses under an accrual method, even if you use the cash method to figure personal items. Filing 1040nr ez Two or more businesses. Filing 1040nr ez   If you operate two or more separate and distinct businesses, you can use a different accounting method for each business. Filing 1040nr ez No business is separate and distinct, unless a complete and separate set of books and records is maintained for each business. Filing 1040nr ez Note. Filing 1040nr ez If you use different accounting methods to create or shift profits or losses between businesses (for example, through inventory adjustments, sales, purchases, or expenses) so that income is not clearly reflected, the businesses will not be considered separate and distinct. Filing 1040nr ez Cash Method Most individuals and many small businesses use the cash method of accounting. Filing 1040nr ez Generally, if you produce, purchase, or sell merchandise, you must keep an inventory and use an accrual method for sales and purchases of merchandise. Filing 1040nr ez See Inventories, later, for exceptions to this rule. Filing 1040nr ez Income Under the cash method, you include in your gross income all items of income you actually or constructively receive during the tax year. Filing 1040nr ez If you receive property and services, you must include their fair market value (FMV) in income. Filing 1040nr ez Constructive receipt. Filing 1040nr ez   Income is constructively received when an amount is credited to your account or made available to you without restriction. Filing 1040nr ez You need not have possession of it. Filing 1040nr ez If you authorize someone to be your agent and receive income for you, you are considered to have received it when your agent receives it. Filing 1040nr ez Income is not constructively received if your control of its receipt is subject to substantial restrictions or limitations. Filing 1040nr ez Example. Filing 1040nr ez You are a calendar year taxpayer. Filing 1040nr ez Your bank credited, and made available, interest to your bank account in December 2012. Filing 1040nr ez You did not withdraw it or enter it into your books until 2013. Filing 1040nr ez You must include the amount in gross income for 2012, the year you constructively received it. Filing 1040nr ez You cannot hold checks or postpone taking possession of similar property from one tax year to another to postpone paying tax on the income. Filing 1040nr ez You must report the income in the year the property is received or made available to you without restriction. Filing 1040nr ez Expenses Under the cash method, generally, you deduct expenses in the tax year in which you actually pay them. Filing 1040nr ez This includes business expenses for which you contest liability. Filing 1040nr ez However, you may not be able to deduct an expense paid in advance. Filing 1040nr ez Instead, you may be required to capitalize certain costs, as explained later under Uniform Capitalization Rules. Filing 1040nr ez Expense paid in advance. Filing 1040nr ez   An expense you pay in advance is deductible only in the year to which it applies, unless the expense qualifies for the 12-month rule. Filing 1040nr ez   Under the 12-month rule, a taxpayer is not required to capitalize amounts paid to create certain rights or benefits for the taxpayer that do not extend beyond the earlier of the following. Filing 1040nr ez 12 months after the right or benefit begins, or The end of the tax year after the tax year in which payment is made. Filing 1040nr ez   If you have not been applying the general rule (an expense paid in advance is deductible only in the year to which it applies) and/or the 12-month rule to the expenses you paid in advance, you must obtain approval from the IRS before using the general rule and/or the 12-month rule. Filing 1040nr ez See Change in Accounting Method, later. Filing 1040nr ez Example 1. Filing 1040nr ez You are a calendar year taxpayer and pay $3,000 in 2012 for a business insurance policy that is effective for three years (36 months), beginning on July 1, 2012. Filing 1040nr ez The general rule that an expense paid in advance is deductible only in the year to which it applies is applicable to this payment because the payment does not qualify for the 12-month rule. Filing 1040nr ez Therefore, only $500 (6/36 x $3,000) is deductible in 2012, $1,000 (12/36 x $3,000) is deductible in 2013, $1,000 (12/36 x $3,000) is deductible in 2014, and the remaining $500 is deductible in 2015. Filing 1040nr ez Example 2. Filing 1040nr ez You are a calendar year taxpayer and pay $10,000 on July 1, 2012, for a business insurance policy that is effective for only one year beginning on July 1, 2012. Filing 1040nr ez The 12-month rule applies. Filing 1040nr ez Therefore, the full $10,000 is deductible in 2012. Filing 1040nr ez Excluded Entities The following entities cannot use the cash method, including any combination of methods that includes the cash method. Filing 1040nr ez (See Special rules for farming businesses, later. Filing 1040nr ez ) A corporation (other than an S corporation) with average annual gross receipts exceeding $5 million. Filing 1040nr ez See Gross receipts test, below. Filing 1040nr ez A partnership with a corporation (other than an S corporation) as a partner, and with the partnership having average annual gross receipts exceeding $5 million. Filing 1040nr ez See Gross receipts test, below. Filing 1040nr ez A tax shelter. Filing 1040nr ez Exceptions The following entities are not prohibited from using the cash method of accounting. Filing 1040nr ez Any corporation or partnership, other than a tax shelter, that meets the gross receipts test for all tax years after 1985. Filing 1040nr ez A qualified personal service corporation (PSC). Filing 1040nr ez Gross receipts test. Filing 1040nr ez   A corporation or partnership, other than a tax shelter, that meets the gross receipts test can generally use the cash method. Filing 1040nr ez A corporation or a partnership meets the test if, for each prior tax year beginning after 1985, its average annual gross receipts are $5 million or less. Filing 1040nr ez    An entity's average annual gross receipts for a prior tax year is determined by: Adding the gross receipts for that tax year and the 2 preceding tax years; and Dividing the total by 3. Filing 1040nr ez See Gross receipts test for qualifying taxpayers, for more information. Filing 1040nr ez Generally, a partnership applies the test at the partnership level. Filing 1040nr ez Gross receipts for a short tax year are annualized. Filing 1040nr ez Aggregation rules. Filing 1040nr ez   Organizations that are members of an affiliated service group or a controlled group of corporations treated as a single employer for tax purposes are required to aggregate their gross receipts to determine whether the gross receipts test is met. Filing 1040nr ez Change to accrual method. Filing 1040nr ez   A corporation or partnership that fails to meet the gross receipts test for any tax year is prohibited from using the cash method and must change to an accrual method of accounting, effective for the tax year in which the entity fails to meet this test. Filing 1040nr ez Special rules for farming businesses. Filing 1040nr ez   Generally, a taxpayer engaged in the trade or business of farming is allowed to use the cash method for its farming business. Filing 1040nr ez However, certain corporations (other than S corporations) and partnerships that have a partner that is a corporation must use an accrual method for their farming business. Filing 1040nr ez For this purpose, farming does not include the operation of a nursery or sod farm or the raising or harvesting of trees (other than fruit and nut trees). Filing 1040nr ez   There is an exception to the requirement to use an accrual method for corporations with gross receipts of $1 million or less for each prior tax year after 1975. Filing 1040nr ez For family corporations engaged in farming, the exception applies if gross receipts were $25 million or less for each prior tax year after 1985. Filing 1040nr ez See chapter 2 of Publication 225, Farmer's Tax Guide, for more information. Filing 1040nr ez Qualified PSC. Filing 1040nr ez   A PSC that meets the following function and ownership tests can use the cash method. Filing 1040nr ez Function test. Filing 1040nr ez   A corporation meets the function test if at least 95% of its activities are in the performance of services in the fields of health, veterinary services, law, engineering (including surveying and mapping), architecture, accounting, actuarial science, performing arts, or consulting. Filing 1040nr ez Ownership test. Filing 1040nr ez   A corporation meets the ownership test if at least 95% of its stock is owned, directly or indirectly, at all times during the year by one or more of the following. Filing 1040nr ez Employees performing services for the corporation in a field qualifying under the function test. Filing 1040nr ez Retired employees who had performed services in those fields. Filing 1040nr ez The estate of an employee described in (1) or (2). Filing 1040nr ez Any other person who acquired the stock by reason of the death of an employee referred to in (1) or (2), but only for the 2-year period beginning on the date of death. Filing 1040nr ez   Indirect ownership is generally taken into account if the stock is owned indirectly through one or more partnerships, S corporations, or qualified PSCs. Filing 1040nr ez Stock owned by one of these entities is considered owned by the entity's owners in proportion to their ownership interest in that entity. Filing 1040nr ez Other forms of indirect stock ownership, such as stock owned by family members, are generally not considered when determining if the ownership test is met. Filing 1040nr ez   For purposes of the ownership test, a person is not considered an employee of a corporation unless that person performs more than minimal services for the corporation. Filing 1040nr ez Change to accrual method. Filing 1040nr ez   A corporation that fails to meet the function test for any tax year; or fails to meet the ownership test at any time during any tax year must change to an accrual method of accounting, effective for the year in which the corporation fails to meet either test. Filing 1040nr ez A corporation that fails to meet the function test or the ownership test is not treated as a qualified PSC for any part of that tax year. Filing 1040nr ez Accrual Method Under the accrual method of accounting, generally you report income in the year it is earned and deduct or capitalize expenses in the year incurred. Filing 1040nr ez The purpose of an accrual method of accounting is to match income and expenses in the correct year. Filing 1040nr ez Income Generally, you include an amount in gross income for the tax year in which all events that fix your right to receive the income have occurred and you can determine the amount with reasonable accuracy. Filing 1040nr ez Under this rule, you report an amount in your gross income on the earliest of the following dates. Filing 1040nr ez When you receive payment. Filing 1040nr ez When the income amount is due to you. Filing 1040nr ez When you earn the income. Filing 1040nr ez When title has passed. Filing 1040nr ez Estimated income. Filing 1040nr ez   If you include a reasonably estimated amount in gross income and later determine the exact amount is different, take the difference into account in the tax year you make that determination. Filing 1040nr ez Change in payment schedule. Filing 1040nr ez   If you perform services for a basic rate specified in a contract, you must accrue the income at the basic rate, even if you agree to receive payments at a reduced rate. Filing 1040nr ez Continue this procedure until you complete the services, then account for the difference. Filing 1040nr ez Advance Payment for Services Generally, you report an advance payment for services to be performed in a later tax year as income in the year you receive the payment. Filing 1040nr ez However, if you receive an advance payment for services you agree to perform by the end of the next tax year, you can elect to postpone including the advance payment in income until the next tax year. Filing 1040nr ez However, you cannot postpone including any payment beyond that tax year. Filing 1040nr ez Service agreement. Filing 1040nr ez   You can postpone reporting income from an advance payment you receive for a service agreement on property you sell, lease, build, install, or construct. Filing 1040nr ez This includes an agreement providing for incidental replacement of parts or materials. Filing 1040nr ez However, this applies only if you offer the property without a service agreement in the normal course of business. Filing 1040nr ez Postponement not allowed. Filing 1040nr ez   Generally, one cannot postpone including an advance payment in income for services if either of the following applies. Filing 1040nr ez You are to perform any part of the service after the end of the tax year immediately following the year you receive the advance payment. Filing 1040nr ez You are to perform any part of the service at any unspecified future date that may be after the end of the tax year immediately following the year you receive the advance payment. Filing 1040nr ez Examples. Filing 1040nr ez   In each of the following examples, assume the tax year is a calendar year and that the accrual method of accounting is used. Filing 1040nr ez Example 1. Filing 1040nr ez You manufacture, sell, and service computers. Filing 1040nr ez You received payment in 2012 for a one-year contingent service contract on a computer you sold. Filing 1040nr ez You can postpone including in income the part of the payment you did not earn in 2012 if, in the normal course of your business, you offer computers for sale without a contingent service contract. Filing 1040nr ez Example 2. Filing 1040nr ez You are in the television repair business. Filing 1040nr ez You received payments in 2012 for one-year contracts under which you agree to repair or replace certain parts that fail to function properly in television sets manufactured and sold by unrelated parties. Filing 1040nr ez You include the payments in gross income as you earn them. Filing 1040nr ez Example 3. Filing 1040nr ez You own a dance studio. Filing 1040nr ez On October 1, 2012, you receive payment for a one-year contract for 48 one-hour lessons beginning on that date. Filing 1040nr ez You give eight lessons in 2012. Filing 1040nr ez Under this method of including advance payments, you must include one-sixth (8/48) of the payment in income for 2012, and five-sixths (40/48) of the payment in 2013, even if you do not give all the lessons by the end of 2013. Filing 1040nr ez Example 4. Filing 1040nr ez Assume the same facts as in Example 3, except the payment is for a two-year contract for 96 lessons. Filing 1040nr ez You must include the entire payment in income in 2012 since part of the services may be performed after the following year. Filing 1040nr ez Guarantee or warranty. Filing 1040nr ez   Generally, you cannot postpone reporting income you receive under a guarantee or warranty contract. Filing 1040nr ez Prepaid rent. Filing 1040nr ez   You cannot postpone reporting income from prepaid rent. Filing 1040nr ez Prepaid rent does not include payment for the use of a room or other space when significant service is also provided for the occupant. Filing 1040nr ez You provide significant service when you supply space in a hotel, boarding house, tourist home, motor court, motel, or apartment house that furnishes hotel services. Filing 1040nr ez Books and records. Filing 1040nr ez   Any advance payment you include in gross receipts on your tax return for the year you receive payment must not be less than the payment you include in income for financial reports under the method of accounting used for those reports. Filing 1040nr ez Financial reports include reports to shareholders, partners, beneficiaries, and other proprietors for credit purposes and consolidated financial statements. Filing 1040nr ez IRS approval. Filing 1040nr ez   You must file Form 3115 to obtain IRS approval to change your method of accounting for advance payment for services. Filing 1040nr ez Advance Payment for Sales Special rules apply to including income from advance payments on agreements for future sales or other dispositions of goods held primarily for sale to customers in the ordinary course of your trade or business. Filing 1040nr ez However, the rules do not apply to a payment (or part of a payment) for services that are not an integral part of the main activities covered under the agreement. Filing 1040nr ez An agreement includes a gift certificate that can be redeemed for goods. Filing 1040nr ez Amounts due and payable are considered received. Filing 1040nr ez How to report payments. Filing 1040nr ez   Generally, include an advance payment in income in the year in which you receive it. Filing 1040nr ez However, you can use the alternative method, discussed next. Filing 1040nr ez Alternative method of reporting. Filing 1040nr ez   Under the alternative method, generally include an advance payment in income in the earlier tax year in which you: Include advance payments in gross receipts under the method of accounting you use for tax purposes, or Include any part of advance payments in income for financial reports under the method of accounting used for those reports. Filing 1040nr ez Financial reports include reports to shareholders, partners, beneficiaries, and other proprietors for credit purposes and consolidated financial statements. Filing 1040nr ez Example 1. Filing 1040nr ez You are a retailer. Filing 1040nr ez You use an accrual method of accounting and account for the sale of goods when you ship the goods. Filing 1040nr ez You use this method for both tax and financial reporting purposes. Filing 1040nr ez You can include advance payments in gross receipts for tax purposes in either: (a) the tax year in which you receive the payments; or (b) the tax year in which you ship the goods. Filing 1040nr ez However, see Exception for inventory goods, later. Filing 1040nr ez Example 2. Filing 1040nr ez You are a calendar year taxpayer. Filing 1040nr ez You manufacture household furniture and use an accrual method of accounting. Filing 1040nr ez Under this method, you accrue income for your financial reports when you ship the furniture. Filing 1040nr ez For tax purposes, you do not accrue income until the furniture has been delivered and accepted. Filing 1040nr ez In 2012, you received an advance payment of $8,000 for an order of furniture to be manufactured for a total price of $20,000. Filing 1040nr ez You shipped the furniture to the customer in December 2012, but it was not delivered and accepted until January 2013. Filing 1040nr ez For tax purposes, you include the $8,000 advance payment in gross income for 2012; and include the remaining $12,000 of the contract price in gross income for 2013. Filing 1040nr ez Information schedule. Filing 1040nr ez   If you use the alternative method of reporting advance payments, you must attach a statement with the following information to your tax return each year. Filing 1040nr ez Total advance payments received in the current tax year. Filing 1040nr ez Total advance payments received in earlier tax years and not included in income before the current tax year. Filing 1040nr ez Total payments received in earlier tax years included in income for the current tax year. Filing 1040nr ez Exception for inventory goods. Filing 1040nr ez   If you have an agreement to sell goods properly included in inventory, you can postpone including the advance payment in income until the end of the second tax year following the year you receive an advance payment if, on the last day of the tax year, you meet the following requirements. Filing 1040nr ez You account for the advance payment under the alternative method (discussed earlier). Filing 1040nr ez You have received a substantial advance payment on the agreement (discussed next). Filing 1040nr ez You have enough substantially similar goods on hand, or available through your normal source of supply, to satisfy the agreement. Filing 1040nr ez These rules also apply to an agreement, such as a gift certificate, that can be satisfied with goods that cannot be identified in the tax year you receive an advance payment. Filing 1040nr ez   If you meet these conditions, all advance payments you receive by the end of the second tax year, including payments received in prior years but not reported, must be included in income by the second tax year following the tax year of receipt of substantial advance payments. Filing 1040nr ez You must also deduct in that second year all actual or estimated costs for the goods required to satisfy the agreement. Filing 1040nr ez If you estimated the cost, you must take into account any difference between the estimate and the actual cost when the goods are delivered. Filing 1040nr ez Note. Filing 1040nr ez You must report any advance payments you receive after the second year in the year received. Filing 1040nr ez No further deferral is allowed. Filing 1040nr ez Substantial advance payments. Filing 1040nr ez   Under an agreement for a future sale, you have substantial advance payments if, by the end of the tax year, the total advance payments received during that year and preceding tax years are equal to or more than the total costs reasonably estimated to be includible in inventory because of the agreement. Filing 1040nr ez Example. Filing 1040nr ez You are a calendar year, accrual method taxpayer who accounts for advance payments under the alternative method. Filing 1040nr ez In 2008, you entered into a contract for the sale of goods properly includible in your inventory. Filing 1040nr ez The total contract price is $50,000 and you estimate that your total inventoriable costs for the goods will be $25,000. Filing 1040nr ez You receive the following advance payments under the contract. Filing 1040nr ez 2009 $17,500 2010 10,000 2011 7,500 2012 5,000 2013 5,000 2014 5,000 Total contract price $50,000   Your customer asked you to deliver the goods in 2015. Filing 1040nr ez In your 2010 closing inventory, you had on hand enough of the type of goods specified in the contract to satisfy the contract. Filing 1040nr ez Since the advance payments you had received by the end of 2010 were more than the costs you estimated, the payments are substantial advance payments. Filing 1040nr ez   For 2012, include in income all payments you received by the end of 2012, the second tax year following the tax year in which you received substantial advance payments. Filing 1040nr ez You must include $40,000 in sales for 2012 (the total amounts received from 2009 through 2012) and include in inventory the cost of the goods (or similar goods) on hand. Filing 1040nr ez If no such goods are on hand, then estimate the cost necessary to satisfy the contract. Filing 1040nr ez   No further deferral is allowed. Filing 1040nr ez You must include in gross income the advance payment you receive each remaining year of the contract. Filing 1040nr ez Take into account the difference between any estimated cost of goods sold and the actual cost when you deliver the goods in 2015. Filing 1040nr ez IRS approval. Filing 1040nr ez   You must file Form 3115 to obtain IRS approval to change your method of accounting for advance payments for sales. Filing 1040nr ez Expenses Under an accrual method of accounting, you generally deduct or capitalize a business expense when both the following apply. Filing 1040nr ez The all-events test has been met. Filing 1040nr ez The test is met when: All events have occurred that fix the fact of liability, and The liability can be determined with reasonable accuracy. Filing 1040nr ez Economic performance has occurred. Filing 1040nr ez Economic Performance Generally, you cannot deduct or capitalize a business expense until economic performance occurs. Filing 1040nr ez If your expense is for property or services provided to you, or for your use of property, economic performance occurs as the property or services are provided or the property is used. Filing 1040nr ez If your expense is for property or services you provide to others, economic performance occurs as you provide the property or services. Filing 1040nr ez Example. Filing 1040nr ez You are a calendar year taxpayer. Filing 1040nr ez You buy office supplies in December 2012. Filing 1040nr ez You receive the supplies and the bill in December, but you pay the bill in January 2013. Filing 1040nr ez You can deduct the expense in 2012 because all events have occurred to fix the liability, the amount of the liability can be determined, and economic performance occurred in 2012. Filing 1040nr ez Your office supplies may qualify as a recurring item, discussed later. Filing 1040nr ez If so, you can deduct them in 2012, even if the supplies are not delivered until 2013 (when economic performance occurs). Filing 1040nr ez Workers' compensation and tort liability. Filing 1040nr ez   If you are required to make payments under workers' compensation laws or in satisfaction of any tort liability, economic performance occurs as you make the payments. Filing 1040nr ez If you are required to make payments to a special designated settlement fund established by court order for a tort liability, economic performance occurs as you make the payments. Filing 1040nr ez Taxes. Filing 1040nr ez   Economic performance generally occurs as estimated income tax, property taxes, employment taxes, etc. Filing 1040nr ez are paid. Filing 1040nr ez However, you can elect to treat taxes as a recurring item, discussed later. Filing 1040nr ez You can also elect to ratably accrue real estate taxes. Filing 1040nr ez See chapter 5 of Publication 535 for information about real estate taxes. Filing 1040nr ez Other liabilities. Filing 1040nr ez   Other liabilities for which economic performance occurs as you make payments include liabilities for breach of contract (to the extent of incidental, consequential, and liquidated damages), violation of law, rebates and refunds, awards, prizes, jackpots, insurance, and warranty and service contracts. Filing 1040nr ez Interest. Filing 1040nr ez   Economic performance occurs with the passage of time (as the borrower uses, and the lender forgoes use of, the lender's money) rather than as payments are made. Filing 1040nr ez Compensation for services. Filing 1040nr ez   Generally, economic performance occurs as an employee renders service to the employer. Filing 1040nr ez However, deductions for compensation or other benefits paid to an employee in a year subsequent to economic performance are subject to the rules governing deferred compensation, deferred benefits, and funded welfare benefit plans. Filing 1040nr ez For information on employee benefit programs, see Publication 15-B, Employer's Tax Guide to Fringe Benefits. Filing 1040nr ez Vacation pay. Filing 1040nr ez   You can take a current deduction for vacation pay earned by your employees if you pay it during the year or, if the amount is vested, within 2½ months after the end of the year. Filing 1040nr ez If you pay it later than this, you must deduct it in the year actually paid. Filing 1040nr ez An amount is vested if your right to it cannot be nullified or cancelled. Filing 1040nr ez Exception for recurring items. Filing 1040nr ez   An exception to the economic performance rule allows certain recurring items to be treated as incurred during the tax year even though economic performance has not occurred. Filing 1040nr ez The exception applies if all the following requirements are met. Filing 1040nr ez The all-events test, discussed earlier, is met. Filing 1040nr ez Economic performance occurs by the earlier of the following dates. Filing 1040nr ez 8½ months after the close of the year. Filing 1040nr ez The date you file a timely return (including extensions) for the year. Filing 1040nr ez The item is recurring in nature and you consistently treat similar items as incurred in the tax year in which the all-events test is met. Filing 1040nr ez Either: The item is not material, or Accruing the item in the year in which the all-events test is met results in a better match against income than accruing the item in the year of economic performance. Filing 1040nr ez This exception does not apply to workers' compensation or tort liabilities. Filing 1040nr ez Amended return. Filing 1040nr ez   You may be able to file an amended return and treat a liability as incurred under the recurring item exception. Filing 1040nr ez You can do so if economic performance for the liability occurs after you file your tax return for the year, but within 8½ months after the close of the tax year. Filing 1040nr ez Recurrence and consistency. Filing 1040nr ez   To determine whether an item is recurring and consistently reported, consider the frequency with which the item and similar items are incurred (or expected to be incurred) and how you report these items for tax purposes. Filing 1040nr ez A new expense or an expense not incurred every year can be treated as recurring if it is reasonable to expect that it will be incurred regularly in the future. Filing 1040nr ez Materiality. Filing 1040nr ez   Factors to consider in determining the materiality of a recurring item include the size of the item (both in absolute terms and in relation to your income and other expenses) and the treatment of the item on your financial statements. Filing 1040nr ez   An item considered material for financial statement purposes is also considered material for tax purposes. Filing 1040nr ez However, in certain situations an immaterial item for financial accounting purposes is treated as material for purposes of economic performance. Filing 1040nr ez Matching expenses with income. Filing 1040nr ez   Costs directly associated with the revenue of a period are properly allocable to that period. Filing 1040nr ez To determine whether the accrual of an expense in a particular year results in a better match with the income to which it relates, generally accepted accounting principles (GAAP; visit www. Filing 1040nr ez fasab. Filing 1040nr ez gov/accepted. Filing 1040nr ez html) are an important factor. Filing 1040nr ez   For example, if you report sales income in the year of sale, but you do not ship the goods until the following year, the shipping costs are more properly matched to income in the year of sale than the year the goods are shipped. Filing 1040nr ez Expenses that cannot be practically associated with income of a particular period, such as advertising costs, should be assigned to the period the costs are incurred. Filing 1040nr ez However, the matching requirement is considered met for certain types of expenses. Filing 1040nr ez These expenses include taxes, payments under insurance, warranty, and service contracts, rebates, refunds, awards, prizes, and jackpots. Filing 1040nr ez Expenses Paid in Advance An expense you pay in advance is deductible only in the year to which it applies, unless the expense qualifies for the 12-month rule. Filing 1040nr ez Under the 12-month rule, a taxpayer is not required to capitalize amounts paid to create certain rights or benefits for the taxpayer that do not extend beyond the earlier of the following. Filing 1040nr ez 12 months after the right or benefit begins, or The end of the tax year after the tax year in which payment is made. Filing 1040nr ez If you have not been applying the general rule (an expense paid in advance is deductible only in the year to which it applies) and/or the 12-month rule to the expenses you paid in advance, you must get IRS approval before using the general rule and/or the 12-month rule. Filing 1040nr ez See Change in Accounting Method, later, for information on how to get IRS approval. Filing 1040nr ez See Expense paid in advance under Cash Method, earlier, for examples illustrating the application of the general and 12-month rules. Filing 1040nr ez Related Persons Business expenses and interest owed to a related person who uses the cash method of accounting are not deductible until you make the payment and the corresponding amount is includible in the related person's gross income. Filing 1040nr ez Determine the relationship for this rule as of the end of the tax year for which the expense or interest would otherwise be deductible. Filing 1040nr ez See section 267 of the Internal Revenue Code and Publication 542, Corporations, for the definition of related person. Filing 1040nr ez Inventories An inventory is necessary to clearly show income when the production, purchase, or sale of merchandise is an income-producing factor. Filing 1040nr ez If you must account for an inventory in your business, you must use an accrual method of accounting for your purchases and sales. Filing 1040nr ez However, see Exceptions, next. Filing 1040nr ez See also Accrual Method, earlier. Filing 1040nr ez To figure taxable income, you must value your inventory at the beginning and end of each tax year. Filing 1040nr ez To determine the value, you need a method for identifying the items in your inventory and a method for valuing these items. Filing 1040nr ez See Identifying Cost and Valuing Inventory, later. Filing 1040nr ez The rules for valuing inventory are not the same for all businesses. Filing 1040nr ez The method you use must conform to generally accepted accounting principles for similar businesses and must clearly reflect income. Filing 1040nr ez Your inventory practices must be consistent from year to year. Filing 1040nr ez The rules discussed here apply only if they do not conflict with the uniform capitalization rules of section 263A and the mark-to-market rules of section 475. Filing 1040nr ez Exceptions The following taxpayers can use the cash method of accounting even if they produce, purchase, or sell merchandise. Filing 1040nr ez These taxpayers can also account for inventoriable items as materials and supplies that are not incidental (discussed later). Filing 1040nr ez A qualifying taxpayer under Revenue Procedure 2001-10 on page 272 of Internal Revenue Bulletin 2001-2, available at www. Filing 1040nr ez irs. Filing 1040nr ez gov/pub/irs-irbs/irb01–02. Filing 1040nr ez pdf. Filing 1040nr ez A qualifying small business taxpayer under Revenue Procedure 2002-28, on page 815 of Internal Revenue Bulletin 2002-18, available at www. Filing 1040nr ez irs. Filing 1040nr ez gov/pub/irs-irbs/irb02–18. Filing 1040nr ez pdf. Filing 1040nr ez In addition to the information provided in this publication, you should see the revenue procedures referenced in the list, above, and the instructions for Form 3115 for information you will need to adopt or change to these accounting methods (see Changing methods, later). Filing 1040nr ez Qualifying taxpayer. Filing 1040nr ez   You are a qualifying taxpayer under Revenue Procedure 2001-10 only if: You satisfy the gross receipts test for each prior tax year ending on or after December 17, 1998 (see Gross receipts test for qualifying taxpayers, next). Filing 1040nr ez Your average annual gross receipts for each test year (explained in Step 1, listed next) must be $1 million or less. Filing 1040nr ez You are not a tax shelter as defined under section 448(d)(3) of the Internal Revenue Code. Filing 1040nr ez Gross receipts test for qualifying taxpayers. Filing 1040nr ez   To determine if you meet the gross receipts test for qualifying taxpayers, use the following steps: Step 1. Filing 1040nr ez List each of the test years. Filing 1040nr ez For qualifying taxpayers under Revenue Procedure 2001-10, the test years are each prior tax year ending on or after December 17, 1998. Filing 1040nr ez Step 2. Filing 1040nr ez Determine your average annual gross receipts for each test year listed in Step 1. Filing 1040nr ez Your average annual gross receipts for a tax year is determined by adding the gross receipts for that tax year and the 2 preceding tax years and dividing the total by 3. Filing 1040nr ez Step 3. Filing 1040nr ez You meet the gross receipts test for qualifying taxpayers if your average annual gross receipts for each test year listed in Step 1 is $1 million or less. Filing 1040nr ez Qualifying small business taxpayer. Filing 1040nr ez   You are a qualifying small business taxpayer under Revenue Procedure 2002-28 only if: You satisfy the gross receipts test for each prior tax year ending on or after December 31, 2000 (see Gross receipts test for qualifying small business taxpayers, next). Filing 1040nr ez Your average annual gross receipts for each test year (explained in Step 1, listed next) must be $10 million or less. Filing 1040nr ez You are not prohibited from using the cash method under section 448 of the Internal Revenue Code. Filing 1040nr ez Your principle business activity is an eligible business. Filing 1040nr ez See Eligible business, later. Filing 1040nr ez You have not changed (or have not been required to change) from the cash method because you became ineligible to use the cash method under Revenue Procedure 2002-28. Filing 1040nr ez Note. Filing 1040nr ez Revenue Procedure 2002-28 does not apply to a farming business of a qualifying small business taxpayer. Filing 1040nr ez A taxpayer engaged in the trade or business of farming generally is allowed to use the cash method for any farming business. Filing 1040nr ez See Special rules for farming businesses under Cash Method, earlier. Filing 1040nr ez Gross receipts test for qualifying small business taxpayers. Filing 1040nr ez   To determine if you meet the gross receipts test for qualifying small business taxpayers, use the following steps: Step 1. Filing 1040nr ez List each of the test years. Filing 1040nr ez For qualifying small business taxpayers under Revenue Procedure 2002-28, the test years are each prior tax year ending on or after December 31, 2000. Filing 1040nr ez Step 2. Filing 1040nr ez Determine your average annual gross receipts for each test year listed in Step 1. Filing 1040nr ez Your average annual gross receipts for a tax year is determined by adding the gross receipts for that tax year and the 2 preceding tax years and dividing the total by 3. Filing 1040nr ez Step 3. Filing 1040nr ez You meet the gross receipts test for qualifying small business taxpayers if your average annual gross receipts for each test year listed in Step 1 is $10 million or less. Filing 1040nr ez Eligible business. Filing 1040nr ez   An eligible business is any business for which a qualified small business taxpayer can use the cash method and choose to not keep an inventory. Filing 1040nr ez You have an eligible business if you meet any of the following requirements. Filing 1040nr ez Your principal business activity is described in a North American Industry Classification System (NAICS) code other than any of the following NAICS subsector codes: NAICS codes 211 and 212 (mining activities). Filing 1040nr ez NAICS codes 31-33 (manufacturing). Filing 1040nr ez NAICS code 42 (wholesale trade). Filing 1040nr ez NAICS codes 44-45 (retail trade). Filing 1040nr ez NAICS codes 5111 and 5122 (information industries). Filing 1040nr ez Your principal business activity is the provision of services, including the provision of property incident to those services. Filing 1040nr ez Your principal business activity is the fabrication or modification of tangible personal property upon demand in accordance with customer design or specifications. Filing 1040nr ez   Information about the NAICS codes can be found at http://www. Filing 1040nr ez census. Filing 1040nr ez gov/naics or in the instructions for your federal income tax return. Filing 1040nr ez Gross receipts. Filing 1040nr ez   In general, gross receipts must include all receipts from all your trades or businesses that must be recognized under the method of accounting you used for that tax year for federal income tax purposes. Filing 1040nr ez See the definit