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EXECUTIVE SUMMARY

* Gain on the sale or disposition of depreciable business property may be recharacterized as ordinary income under various recapture provisions.

* For Sec. 1245 property, all depreciation claimed or allowable is subject to recapture, up to the total gain amount.

* Corporations are subject to Sec. 291, which recaptures up to 20% of the gain in excess of Sec. 1250 recapture; individuals are subject to a 25% capital gain rate on unrecaptured Sec. 1250 gain.

Tax advisers and their clients should know how the depreciation recapture provisions can operate to recharacterize capital gain as ordinary income. Part I of this two-part article explains the basic rules that apply to corporate and individual taxpayers.

Depreciation recapture can be minimized with proper planning. The depreciation recapture provisions and their application to both corporate and individual taxpayers are discussed and illustrated in Part I of this article, below. Part II, in the August 2005 issue, will cover exceptions to the recapture rules, gain reporting and recapture planning.

Background

The creation of Sec. 1231 initially gave businesses disposing of long-term depreciable assets the best of all possible worlds: net Sec. 1231 gains were preferentially taxed as long-term capital gains, while net Sec. 1231 losses were fully deductible as ordinary losses. By 1962, however, Congress felt taxpayers were abusing Sec. 1231 to convert ordinary income into capital gains. Businesses claimed accelerated depreciation deductions against ordinary income, rapidly lowering a property’s basis and increasing the opportunity for gain on disposal. Any resulting gain, however, was not ordinary income but, rather, potential long-term capital gain under Sec. 1231(a). In response, Congress passed Secs. 1245 and 1250, to convert all or part of the capital gain to ordinary income through depreciation recapture. Subsequent legislation introduced Sec. 291 recapture for corporations, as well as the special 25% recapture rate on unrecaptured Sec. 1250 gain for individuals.

Basic Principles

Depreciation recapture applies to the disposal of an asset only when (1) property was held on a long-term basis (more than one year), (2) depreciation or amortization was claimed on the property and (3) the property was disposed of at a gain.

Example 1: J wishes to sell the following assets used in his business:

1. Equipment held 9 months (fair market value (FMV) $20,000; adjusted basis $17,000).

2. Land held 5 years (FMV $80,000; basis $40,000).

3. Furniture held 3 years (FMV $30,000; adjusted basis $48,000).

4. A building held 10 years (FMV $500,000; adjusted basis $325,000).

Of the four assets, depreciation recapture would apply only to the building. The other items are not subject to depreciation recapture, because the equipment has not been held for over a year (all of its gain on disposal will be ordinary income), the land is not subject to depreciation (all of its gain will be Sec. 1231 gain) and the furniture’s disposal results in a Sec. 1231 loss.

The recapture provisions generally do not determine the realized or recognized gain or loss on an asset’s disposal; rather, they determine only the tax character of any gain. Recapture provisions such as Secs. 1245 and 1250 take precedence over other Code sections and, in isolated cases, may require gain recognition despite the existence of other nonrecognition provisions. (1)

Sec. 1245 Recapture

Sec. 1245 classifies gains on the disposition of qualifying assets as ordinary income, equal to all depreciation claimed since 1962. However, the ordinary income cannot exceed the total gain. Thus, Sec. 1245 ordinary income is the lesser of total recognized gain or all depreciation chimed.

The depreciation or amortization method used (e.g. accelerated or straight-line) does not affect Sec. 1245 depreciation recapture. All depreciation claimed or allowable is subject to recapture. As a result, Sec. 1245 recaptures (1) depreciation claimed under Sec. 167, (2) cost recovery under Sec. 168, (3) Sec. 197 amortization, (4) expensing under Sec. 1792 and (5) the additional 30% or 50% first-year depreciation deduction under Sec. 168(k)(1)(A) and (4)(A)(i).

Example 2: T placed in service a $160,000 plating machine (7-year property under the modified accelerated cost recovery system (MACRS)) in September 2003. T elected to expense $100,000 of the cost under Sec. 179 and used 50% bonus depreciation for the excess. In 2005, T sells the machine for $120,000. T’s adjusted basis at the time of the sale is $15,743, computed as follows:

T’s recognized gain is $104,257 ($120,000 amount realized—$15,743 adjusted basis). The entire $104,257 gain is recaptured as ordinary income under Sec. 1245, because it is less than the $144,257 total depreciation taken (which includes the Sec. 179 deduction and 50% bonus depredation).

Any gain greater than total depreciation is Sec. 1231 gain. This will rarely occur, because it requires disposing of the asset at more than its original cost—not usually the case with business personalty.

Example 3: The facts are the same as in Example 2, except that T sells the machine for $170,000. Sec. 1245 recaptures $144,257 of the gain as ordinary income (total depreciation taken); the remaining $10,000 is Sec. 1231 gain.

Sec. 1245’s operation is further illustrated in the three examples shown in Exhibit 1 on p. 420, which show the character of the recognized gain or loss for three hypothetical disposal values of a business machine. Note: the definition of Sec. 1245 property (primarily, depreciable personalty held on a long-term basis, under Sec. 1245(a)(3)) also falls within the broader definition of Sec. 1231 property (property used in a trade or business and held on a long-term basis, under Sec. 1231(b)). For that reason, the loss in Example A of Exhibit 1 is a Sec. 1231 loss (Sec. 1245 applies only to gains), and the gain in excess of recapture in Example C is Sec. 1231 gain. Also, the Sec. 1231 gain in Example C represents the excess of the amount realized over the asset’s original cost, as that amount was never depreciated.

Defining Sec. 1245 property: Sec. 1245 property generally falls into one of three categories:

1. Tangible depreciable personal property, such as equipment.

2. Intangible amortizable personal property, such as patents.

3. Nonresidential depreciable real property acquired after 1980 and before 1987, on which accelerated cost recovery was taken. (3)

Exhibit 2 on p. 421 shows additional Sec. 1245 categories. Most buildings and their structural components are Sec. 1250 property, not Sec. 1245 property. (4) Sec. 1245 also applies to nonstructural realty that is an integral part of manufacturing or production. However, as indicated above, nonresidential realty depreciated under ACRS is Sec. 1245 property. If a taxpayer elected straight-line ACRS for depreciable realty between 1980 and 1987, Sec. 1250 would govern the depredation recapture.

Sec. 1250 Recapture

Sec. 1250 creates ordinary income only if accelerated depreciation was claimed on realty placed in service after 1970 and before 1981, or on residential realty placed in service after 1980 and before 1987. (If a taxpayer placed nonresidential realty in service after 1980, but before 1987, and applied ACRS, Sec. 1245 applies, not Sec. 1250.)

In enacting these provisions in 1964, Congress did not want to dampen the real estate market with a recapture rule as severe as the one enacted for Sec. 1245 property in 1962. Thus, rather than recapturing all depreciation like Sec. 1245, it provided that Sec. 1250(a) would recapture only a percentage of the lesser of total recognized gain or excess depreciation (i.e. the difference between the actual depreciation taken over straight-line depreciation). Under the recapture rules, the recapture percentage is always applied to the lesser of excess depreciation or the remaining gain to be recognized.

Excess depreciation is computed by comparing the aggregate accelerated and straight-line totals across all years, including those years in which straightline depreciation exceeds accelerated depreciation. Thus, the maximum recapture potential begins to decrease once the depreciation calculations reach the point at which straight-line deductions exceed accelerated deductions. There is no recapture potential for an asset held for its entire cost-recovery life, because excess depreciation at that time is zero.

When straight-line depreciation is claimed, Sec. 1250 recaptures no ordinary income, because there is no excess of actual depreciation over the hypothetical recalculation of depreciation using the straight-line method. Because current MACRS rules require the use of straight-line depreciation for realty acquired after 1986, there is no Sec. 1250 recapture for such depreciable realty, whether residential or nonresidential. (5)

However, even though the effect of Sec. 1250 may be zero, a corporate taxpayer will have to contend with recognizing ordinary income under Sec. 291; a noncorporate taxpayer may be affected by the 25% rate on unrecaptured Sec. 1250 gain. Both of these situations are discussed below.

Thus, for Sec. 1250 to apply, the taxpayer must have claimed accelerated depreciation on realty placed in service before 1987 and realized gain on disposition of the property. A loss on disposal of long-term depreciable realty will always be a Sec. 1231 loss, because Sec. 1250 applies only to gains.

Defining Sec. 1250 property: Under Sec. 1250(c), Sec. 1250 property is depreciable realty (1) placed into service after 1964, (2) held on a long-term basis and (3) disposed of at a gain. While Sec. 1250 generally applies to tangible depreciable real property (e.g. buildings and structural components), some intangibles (such as leaseholds of realty) are also included. Exhibit 3 below presents common Sec. 1250 categories.

Sec. 1250 calculations differ depending on when the property was placed in service and whether the asset is residential or nonresidential realty or low-income housing. Property qualifies as residential rental housing if at least 80% of its gross rental income is derived from dwelling units; (6) otherwise, it is classified as nonresidential realty. Exhibit 4 on p. 422 illustrates how Sec. 1250 recapture rules apply to dispositions of residential and nonresidential properties for three different acquisition dates and cost-recovery assumptions. As discussed above, Sec. 1250 does not apply to real estate placed in service after 1986 (straightline recovery is required for such assets). As for realty placed in service before 1987, recapture is limited to 100% of excess depreciation in all categories but one—nonresidential realty placed in service under ACRS. As mentioned earlier, recapture on such property is computed using the Sec. 1245 rules if accelerated recovery was used. If straight-line recovery was elected, then Sec. 1250 controls, and there is no recapture (because there is no excess depreciation).

Historically, the total Sec. 1250 recapture amount was subject to special phase-out rules based on how long the property was held. For example, any excess depreciation taken before 1976 on residential realty was subject to recapture; however, under Sec. 1250(a)(2)(B)(iv), the recapture percentage was reduced by 1% for each month that the property was held in excess of 100 months. Thus, for sales or exchanges of such properties after October 1992, recapture is completely phased out.

Sec. 291 Recapture

Congress further reduced the benefits of Sec. 1231 capital gain treatment for corporate taxpayers in years after 1982 by creating Sec. 291, which recaptures up to 20% of the gain in excess of Sec. 1250 recapture. Sec. 291 applies to C corporations. According to Sec. 1363(b)(4), S corporations are affected only if they operated as C corporations for the three tax years immediately preceding the S election.

Under Sec. 291 (a)(1), ordinary income is 20% of the difference between the amount Sec. 1245 would have recaptured as ordinary income and the amount Sec. 1250 actually recaptures. For residential realty, Sec. 291 applies whether straight-line or ACRS is selected. For nonresidential realty, Sec. 291 applies only if straight-line depreciation is used, because Sec. 1245 controls when ACRS is chimed and recaptures all depreciation.

Exhibit 5 on p. 423 shows the effects of the various depreciation recapture rifles on a corporate taxpayer’s disposition of either nonresidential or residential realty, assuming it was placed into service in one of three time periods. Sec. 1231 gains are further analyzed in Exhibit 5 by the maximum marginal income tax rates that would apply to each type of gain (35% for corporations; 15% or 25% for individuals). Note: Sec. 291 affects a corporate taxpayer in all situations, except when ACRS was selected for nonresidential realty.

Sec. 291 gain is always a maximum of 20% of the unrecaptured depreciation taken on the realty. For example, in Exhibit 5, the Sec. 291 recapture on the realty placed in service in 1975 is 20% of $160,000, which is the portion of the total $200,000 depreciation allowed, but not recaptured under Sec. 1245 ($40,000).

Unrecaptured Sec. 1250 Gain

The Jobs and Growth Tax Relief Reconciliation Act of 2003 reduced capital gain rates to 15% for assets sold after May 5, 2003. (7) However, this treatment does not apply to depreciable real property. Noncorporate taxpayers face a special 25% capital gain rate under Sec. 1(h)(1)(D) that applies to Sec. 1231 gain otherwise taxable as 15% long-term capital gain on the sale or exchange of depreciable real property. The 25% rate applies to the portion of the Sec. 1231 gain on depreciable realty, representing the difference between the amount Sec. 1245 would have recaptured as ordinary income and the amount Sec. 1250 actually recaptures. This unrecaptured Sec. 1250 gain actually represents the same amount of Sec. 1231 gain of which 20% is subject to Sec. 291 for corporate taxpayers. Thus, while an individual taxpayer can avoid Sec. 1250 recapture on dispositions of long-term depreciable realty by using straight-line depreciation, most or all of the Sec. 1231 gain will still be subject to the 25% rate.

Exhibit 5 above shows the effects of the depreciation recapture rules on an individual’s gain on disposition of nonresidential and residential realty. The unrecaptured gain is initially computed as if Sec. 1245 recapture applied (gain to the extent of total depreciation taken). This amount is then reduced by any Sec. 1250 ordinary income recapture; the remainder is labeled unrecaptured Sec. 1250 gain which qualifies for the 25% rate. For example, total depredation taken on 1975 nonresidential property is $200,000, Sec. 1250 recapture is $40,000, and, thus, the 25% rate gain is the $160,000 difference. Any gain exceeding these two recaptures is Sec. 1231 gain, which will qualify for the 15% rate.

Note: Sec. 1250 ceases to affect dispositions after 1987, when MACRS straight-line cost recovery applies. In contrast, the 25% unrecaptured Sec. 1250 gain rate affects all but one of Exhibit 5’s examples, restricting taxpayer access to the more favorable 15% gain rate.

Conclusion

The depreciation recapture provisions are among the most pervasive and complicated areas of the Code. However, taxpayers using depreciable assets in business—and their tax advisers—must understand how the recapture provisions operate to turn Sec. 1231 gain into ordinary income, and how they subject gains on dispositions of depreciable realty to the higher 25% capital gain rate, rather than to the 15% rate. Part II, in the August 2005 issue, will discuss exceptions to the recapture provisions and suggest tax planning strategies.

(1) See Regs. Secs. 1.1245-6(a) and 1.1250-1(c)(1).

(2) See Sec. 1245(a)(2)(C).

(3) See Sec. 1245(a)(5) before repeal by the Tax Reform Act of 1986 (TRA ’86).

(4) See Sec. 1245(a)(3)(B).

(5) See Sec. 1245(a)(5)(C) before repeal by the TRA ’86.

(6) See Sec. 168(e)(2)(A).

(7) The rate is 5% for individuals in the 15% or 10% tax brackets.

John O. Everett, PhD. CPA