17
Property Transactions:
Dispositions of Trade
or Business Property
Learning Objectives
Upon completion of this chapter you will be able to:
LO.1 Trace the historical development of
the special tax treatment allowed for
dispositions of trade or business property.
LO.2 Define § 1231 property
LO.3 Apply the § 1231 gain and loss netting
process to a taxpayer’s § 1231 asset
transactions
LO.4 Explain the purpose of the depreciation
recapture rules
LO.5 Compute depreciation recapture
under § 1245
LO.6 Compute depreciation recapture
under § 1250
LO.7 Explain the additional recapture rule
applicable only to corporate taxpayers
LO.8 Identify tax planning opportunities
related to sales or other dispositions of
trade or business property
Chapter Outline
Introduction17-2
Section 1231
17-2
Historical Perspective
17-2
Section 1231 Property
17-3
Other § 1231 Property
17-4
Section 1231 Netting Process
17-6
Look-Back Rule
17-10
Applicability of Lower Rates
17-11
Depreciation Recapture
17-13
Historical Perspective
17-13
When Applicable
17-14
Types of Depreciation Recapture
17-14
Full Recapture—§ 1245
17-15
Partial Recapture—§ 1250
17-17
Additional Recapture—
Corporations
17-35
Other Recapture Provisions
17-36
Related Business Issues
Installment Sales of Trade or
Business Property
Intangible Business Assets
Dispositions of Business Assets and
the Self-Employment Tax
Tax Planning Considerations
Timing of Sales and
Other Dispositions
Selecting Depreciation Methods
Installment Sales
Sales of Businesses
Dispositions of Business Assets and
the Self-Employment Tax
Problem Materials
17-38
17-38
17-39
17-39
17-40
17-40
17-40
17-41
17-41
17-41
17-42
17-1
17-2
Chapter 17
Property Transactions: Dispositions of Trade or Business Property
Introduction
As is no doubt clear by now, the treatment of property transactions is a complex story that
seeks to answer three questions: (1) What is the gain or loss realized? (2) How much is
recognized? and (3) What is its character? This chapter, the final act in the property transaction trilogy, addresses the problems in determining the character of gains or losses on the
dispositions of property used in a trade or business.
In an uncomplicated world, it might seem logical to assume that gains or losses from
property dispositions—be it stock, equipment, buildings, or whatever—would be treated
just like any other type of income or deduction. But, as shown in the previous chapter, treating all items alike apparently was not part of the grand plan. Congress forever changed the
process with the institution of preferential treatment for capital gains in 1921. Since that
time taxpayers have been required to determine not only the gain or loss realized and recognized but also whether a disposition involved a capital asset. It is important to understand
that these rules did not simply tip the scales in favor of capital gain. In the interest of fairness and equity, they also established a less than friendly environment for capital losses. The
limitations on the deductibility of capital losses is clearly a major disadvantage, particularly
considering that ordinary losses are fully deductible. The end result of Congress’s handiwork was the creation of a system in which the preferred result is capital gain treatment
for gains and ordinary treatment for losses. This chapter contains the saga of what happens
when Congress attempts to provide taxpayers with the best of both worlds.
Section 1231
The road to tax heaven—capital gain and ordinary loss—begins at § 1231 (in tax parlance
properly pronounced as “twelve thirty-one”). While § 1231 can be a completely bewildering provision, its basic operation is relatively simple. At the close of the taxable year, the
taxpayer nets all gains and losses from so-called § 1231 property (e.g., land and depreciable
property used in a trade or business). If there is a net gain, it is treated as a long-term capital
gain. If there is a net loss, it is treated as an ordinary loss. In short, § 1231 allows taxpayers
to have their cake and eat it, too. Unfortunately, this is accomplished only with a great deal
of complexity, much of which makes sense only if the historical events that shaped § 1231
are considered.
H istorical P erspective
LO.1
Trace the historical
development of the
special tax treatment
allowed for dispositions
of trade or business
property.
At first glance, it seems that the productive assets of a business—its property, plant, and
equipment—would be perfect candidates for capital gain treatment and would therefore be
considered capital assets. Indeed, that was exactly the case initially. From 1921 to 1938,
real or depreciable property used in business was in fact treated as a capital asset. At that
time, the classification of such property as a capital asset seemed not only appropriate but
desirable—particularly as the economy grew during the early 1920s and taxpayers were
realizing gains. However, the opposite became true with the onset of the Great Depression.
As the economy deteriorated, businesses that had purchased assets at inflated prices during the booming 1920s found themselves selling such properties at huge losses during the
depression-plagued 1930s. To make matters worse, the tax law treated such losses as capital losses, severely limiting their deduction. But Congress apparently had a sympathetic
ear for these concerns. Hoping that a change would help stimulate the economy, Congress
enacted legislation that removed business properties from the list of capital assets. The
legislative history to the Revenue Act of 1938 provides some insight into Congressional
thinking, explaining that “corporations will not, as formerly, be deterred from disposing of
partially obsolescent property, such as machinery or equipment, because of the limitations
imposed … upon the deduction of capital losses.”1 With the 1938 changes in place, business
got the ordinary loss treatment it wanted but at the same time was saddled with ordinary
income treatments for its gains.
1
ouse Ways and Means Committee, H.R. Rep. 1860, 75th
H
Cong., 3d Sess. (1938).
17-3
Section 1231
Although these rules worked well during the Depression years as businesses were reporting losses, they produced some unduly harsh results once the country moved to a wartime economy. By 1942, the build-up for World War II had the economy humming and
inflation had once again set in. Businesses that earlier had sold assets for 10 cents on the
dollar now found themselves realizing gains. Of course, under the 1938 changes these gains
no longer benefited from preferential treatment but were taxed at extraordinarily high tax
rates (88 percent for individuals and 40 percent for corporations). The shipping industry
was particularly hard hit by the new treatment. Shippers not only had gains as the enemy
destroyed their insured ships but also profited when they were forced to sell their property
to the government for use in the war. Other businesses that had their factories and equipment condemned and requisitioned also felt the sting of higher ordinary rates. Although
these companies could have deferred their gains had they replaced the property under the
involuntary conversion rules of § 1033, qualified reinvestment property was in short supply,
making § 1033 virtually useless. Understanding the plight of business, Congress once again
came to the rescue. In 1942, Congress enacted legislation generally reinstating capital gain
treatment but preserving ordinary loss treatment.
The changes in 1942 stemmed primarily from a need to provide relief for those whose
property was condemned for the war effort. But in the end they went much further. For consistency, capital gain treatment was extended not only to condemnations of a business property but to other types of involuntary conversions as well. Under the new rules, casualty and
theft gains from business property and capital assets also received capital gain treatment. In
addition, the new legislation unexpectedly extended capital gain treatment to regular sales
of property, plant, and equipment. Apparently, Congress felt that capital gain treatment
was also appropriate for taxpayers who were selling out in anticipation of condemnation or
simply because wartime conditions had made operations difficult. While Congress thought
capital gain treatment was warranted for these gains, it also knew that other businesses had
not profited from the war and were still suffering losses from their property transactions.
Accordingly, it acted to preserve ordinary loss treatment. The end result of these maneuvers
was the enactment of § 1231, an extremely complex provision that provides taxpayers with
the best of all possible tax worlds: capital gain and ordinary loss.
The product of Congressional tinkering in 1942 still remains today. To summarize, real
and depreciable property used in a trade or business is specifically denied capital asset status. But this does not necessarily mean that such property will be denied capital gain treatment. As explained at the outset, § 1231 generally extends capital gain treatment to gains
and losses from these assets if the taxpayer realizes a net gain from all § 1231 transactions.
On the other hand, if there is a net loss, ordinary loss treatment applies. But this summary
lacks a great deal of precision. The specific rules of § 1231 are described below.
S ection 1231 P roperty
The special treatment of § 1231 is generally granted only to certain transactions involving
assets normally referred to as § 1231 property.2 Section 1231 property includes a variety
of assets, but among them the most important is real or depreciable property that is used
in the taxpayer’s trade or business and that is held for more than one year.3 This definition
takes in most items commonly identified as a business’s fixed assets, normally referred to
as its property, plant, and equipment. For example, the reach of § 1231 includes depreciable
personal property used in business, such as machinery, equipment, office furniture, and
business automobiles. Similarly, realty used in a business, such as office buildings, warehouses, factories, and farmland, is also considered § 1231 property.
2
s explained below, § 1231 also applies to involuntary
A
conversions of pure capital assets held more than one year
that are used in a trade or business or held for investment.
Involuntary conversions by theft or casualty of personal
assets are not included under § 1231 but are subject to a
special computation.
3
he holding period is determined in the same manner as it is
T
for capital assets. See § 1223 discussed in Chapter 16.
LO.2
Define § 1231
property
17-4
Chapter 17
Property Transactions: Dispositions of Trade or Business Property
The Code specifically excludes the following assets from § 1231 treatment:
1. Property held primarily for sale to customers in the ordinary course of a trade or business, or includible in inventory, if on hand at the close of the tax year;
2. A copyright; a literary, musical, or artistic composition; a letter or memorandum; or
similar property held by a taxpayer whose personal efforts created such property or
by certain other persons; or
3. A publication of the United States Government received from the government other than
by purchase at the price at which the publication is offered to the general public.4
Note that the excluded assets are also excluded from the definition of a capital asset. As a
result, gains or losses on the disposition of inventory, property held primarily for resale,
literary compositions, and certain government publications always yield ordinary income
or ordinary loss.
One of the critical conditions for § 1231 treatment requires that the property be used
in a trade or business. Although this test normally presents little difficulty, from time to
time it has created problems, particularly for those with rental property. As an illustration,
consider the common situation of a taxpayer who sells rental property such as a house,
duplex, or apartment complex. Is the property sold a capital asset or § 1231 property? If a
taxpayer sells rental property at a gain, the gain would normally receive capital gain treatment regardless of whether the property is a capital asset or § 1231 property. On the other
hand, if the taxpayer sells the rental property at a loss, § 1231 treatment is usually far more
desirable. Although the Code does not provide any clear guidance on the issue, the courts
have generally held that property used for rental purposes is considered as used in a trade or
business and is therefore eligible for § 1231 treatment.5
O ther § 1231 P roperty
From time to time, Congress has been convinced that particular industries deserve special
tax relief. As a result, it has added a number of other properties to the § 1231 basket. Those
eligible for capital gain and ordinary loss are:
1. Timber, coal, and iron ore to which § 631 applies;6
2. Unharvested crops on land used in a trade or business and held for more than one
year;7 and
3. Certain livestock.8
Timber
Under § 631, the mere cutting of timber by the owner of the timber, or by a person who
has the right to cut the timber and has held the timber or right more than one year, is to be
treated, at his or her election, as a sale or exchange of the timber that is cut during the year.
The timber must be cut for sale or for use in the taxpayer’s trade or business. In such case,
the taxpayer would report a § 1231 gain or loss and potentially receive capital gain treatment for what otherwise might be considered the taxpayer’s inventory—a very favorable
result. It may appear that the timber industry has secured an unfair advantage, but timber’s
eligibility is arguably justified on the grounds that the value of timber normally accrues
incrementally as it grows over a long period of time.
The amount of gain or loss on the “sale” of the timber is the fair market value of the timber on the first day of the taxable year minus the timber’s adjusted basis for depletion. For all
subsequent purposes (i.e., the sale of the cut timber), the fair market value of the timber as of
the beginning of the year will be treated as the cost of the timber. The term timber not only
includes trees used for lumber and other wood products, but also includes evergreen trees that
4
§ 1231(b)(1).
6
§ 1231(b)(2).
5
ee, for example, Mary Crawford, 16 T.C. 678 (1951) A.
S
1951-2 C.B. 2, and Gilford v. Comm., 53-1 USTC ¶9201, 43
AFTR 221, 201 F.2d 735 (CA-2, 1953).
7
§ 1231(b)(4).
8
§ 1231(b)(3).
Section 1231
are more than six years old when cut and are sold for ornamental purposes (e.g., Christmas
trees).9
Example 1
B owned standing timber that he had purchased for $250,000 three years earlier. The
timber was cut and sold to a lumber mill for $410,000 during 2012. The fair market
value of the standing timber as of January 1, 2012 was $320,000. B has a § 1231 gain
of $70,000 if he makes an election under § 631 ($320,000 fair market value of the
timber on the first day of the taxable year less its $250,000 adjusted basis for depletion). The remainder of his gain on the actual sale of the timber, $90,000 ($410,000
selling price − $320,000 new “cost” of the timber), is ordinary income. Any expenses
incurred by B in cutting the timber would be deductible as ordinary deductions.
An election under § 631 with respect to timber is binding on all timber owned by the
taxpayer during the year of the election and in all subsequent years. The IRS may permit
revocation of such election because of significant hardship. However, once the election is
revoked, IRS consent must be obtained to make a new election.10
Section 631 also applies to the sale of timber under a contract providing a retained economic interest (i.e., a taxpayer sells the timber, but keeps the right to receive a royalty from
its later sale) for the taxpayer in the timber. In such a case, the transfer is considered a sale
or exchange. The gain or loss is recognized on the date the timber is cut, or when payment
is received, if earlier, at the election of the taxpayer.11
Coal and Iron Ore
When an owner disposes of coal or domestic iron ore under a contract that calls for a retained economic interest in the property, the disposition is treated as a sale or exchange of
the coal or iron ore. The date the coal or ore is mined is considered the date of sale and since
the property is § 1231 property, the gain or loss will be treated under § 1231.12
The taxpayer may not be a co-adventurer, partner, or principal in the mining of the coal
or iron ore. Furthermore, the coal or iron ore may not be sold to certain related taxpayers.13
Unharvested Crops
Section 1231 also addresses the special situation where a farmer sells land with unharvested
crops sitting upon the land. In this case, it seems logical that the farmer should allocate the
sales price between the crops and the land to ensure ordinary income or loss for the sale of
the farmer’s inventory and capital gain or ordinary loss on the sale of the land. While this
may be the theoretically correct result, Congress wanted to eliminate potential controversy
over the allocation. Accordingly, for administrative convenience it brought the entire transaction into the § 1231 fold in 1951. Currently, whenever land used in a trade or business
and unharvested crops on that land are sold at the same time to the same buyer, the gain or
loss is subject to § 1231 treatment as long as the land has been held for more than a year.14
It is worth noting that the benefits of § 1231 were not extended to farmers free of charge.
At the same time, Congress eliminated the current deduction for production expenses. The
law now provides that any expenses related to the production of crops cannot be deducted
currently but must be capitalized as part of the basis of the crops.15 Such treatment, in a year
when land and crops are sold, reduces the farmer’s capital gain on the sale rather than any
other ordinary income.
9
§ 631(a).
13
§§ 631(c)(1) and (2).
§ 1231(b)(4).
§ 268.
Ibid.
14
11
§ 631(b).
15
12
§ 631(c).
10
17-5
17-6
Chapter 17
Property Transactions: Dispositions of Trade or Business Property
Example 2
F sold 100 acres of land used in his farming business just days before the corn on the
land was harvested. For the “package” deal, he received $600,000, including an estimated $70,000 for the unharvested crops that he figured had cost $20,000 to produce.
F had purchased the land in 2000 for $200,000. In determining the character of his
gain, F is not required to allocate the sales price between the crops and the land since
he sold both at the same time to the same buyer, therefore qualifying for § 1231 treatment. He will recognize a § 1231 gain of $380,000 computed as follows:
Sales price. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Adjusted basis ($200,000 1 $20,000) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $600,000
−220,000
§ 1231 gain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $380,000
Note that F has effectively turned the $50,000 ($70,000 − $20,000) profit from the
sale of his crops from ordinary income into potential capital gain.
Livestock
Livestock that are used for breeding and other income producing purposes are depreciable
assets much like machinery and thus qualify for § 1231 treatment. In many situations, however, livestock are used for these purposes for only a short period of time and then sold. If
this is the farmer’s or rancher’s normal practice, the IRS is inclined to argue that the animals
are held primarily for resale, in which case the law specifically denies § 1231 treatment.
To help end this controversy, Congress specifically made all livestock (other than poultry)
used for draft, breeding, dairy, or sporting purposes eligible for § 1231 treatment if they are
held for over a year.16 In the case of cattle and horses, the holding period is extended to two
years. Note that this treatment is extremely beneficial since the taxpayer effectively gets
capital gain from animals pulled out of the breeding process and sold. Moreover, the farmer
or rancher is allowed to deduct the costs of raising such animals currently against ordinary
income. The extension of the holding period for cattle and horses was in part, an attempt to
cut back on the benefits of this favorable treatment.
S ection 1231 N etting P rocess
LO.3
Apply the § 1231
gain and loss
netting process to
a taxpayer’s § 1231
asset transactions.
The treatment of § 1231 gains or losses ultimately depends on the outcome of a netting process that is far more complicated than outlined earlier.17 As can be seen from the flowchart
in Exhibit 17.1, the taxpayer must first identify all of the gains and losses that enter into
the netting process. These include gains and losses from what has been described above as
§ 1231 property. Also, the § 1231 “bucket” includes involuntary conversions of certain capital assets. Surprisingly, gains or losses recognized from casualties, thefts, or condemnations
of capital assets that are used in a trade or business or held for investment are part of the
§ 1231 netting process. Involuntary conversions of capital assets that are held for personal
use are not considered under § 1231 but are subject to special rules.
After identifying all of the § 1231 transactions, the taxpayer must segregate the § 1231
gains and losses arising from casualty and theft from those attributable to sale, exchange,
and condemnation. The end result is that there are two sets of § 1231 transactions:
1. Involuntary conversions due to casualty and theft of:
• § 1231 property
• Real and depreciable property used in business and held more than one year
• Timber, coal, iron ore, unharvested crops, and livestock
• Capital assets
• Used in a trade or business or held for investment in connection with business
and held more than one year
16
§ 1231(b)(3).
17
§ 1231(a).
Section 1231
2. Sales and exchanges of:
• § 1231 property
• Real and depreciable property used in business
• Timber, coal, iron ore, unharvested crops and livestock
Involuntary conversion due to condemnation of:
• § 1231 property
• Real and depreciable property used in business and held more than one year
• Timber, coal, iron ore, unharvested crops, and livestock
• Capital assets
• Used in a trade or business or held for investment in connection with business
and held more than one year
EXHIBIT 17.1
Section 1231 Netting Process
Gains* and losses from sales or
exchanges of § 1231 assets
and specified involuntary
conversions
Casualty and theft gains*
and losses from §1231
assets and specified
capital assets
Net
(Step 1)
Net
(Step 2)
If
Gain
If
Loss
If
Gain
Treat net result
as an ordinary
deduction
Look-Back Rule:
Did the taxpayer
deduct any net
§ 1231 losses in
the last five
taxable years?
If
Loss
Treat gains and losses
separately: gains are
ordinary income: business
losses are deductions
for A.G.I.: other
losses are deductions
from A.G.I.
If
Yes
If
No
Treat as ordinary income
the lesser of
(1) unrecaptured § 1231
losses, or (2) the current
year’s net gain. Treat any
excess § 1231 gain as 15%
or 28% capital gain
Treat entire
net gain as a
15% or 28%
capital gain
* Gains remaining after reduction for any depreciation recapture
17-7
17-8
Chapter 17
Property Transactions: Dispositions of Trade or Business Property
Within each of these two categories, each gain and loss is assigned to one of the three potential
long-term capital gain groups and netted just as if they had been 28%, 25% or 15% capital
gains or losses (see Chapter 16). This means that each § 1231 gain or loss is assigned to one
of the following categories: (1) 15% group for § 1231 gains and losses (15G or 15L); (2)
25% group for unrecaptured § 1250 depreciation on gains from § 1231 assets (25G discussed
below); and (3) 28% group for gains and losses from collectibles (28G or 28L). Once all of
the appropriate transactions have been poured into the § 1231 process, the netting process can
begin. There are three steps.
1. First, all of the gains and losses in the first category of § 1231 transactions (casualties
and thefts) are netted. Specifically, gains and losses within the 15% and 28% groups
are netted to arrive at one of the following: (1) a net gain or loss on 15% § 1231 assets
(N15G or N15L); and (2) a net gain or loss on 28% § 1231 assets (N28G or N28L).
Any net loss positions are then combined with the net gain positions using the rules
discussed for netting the three groups for capital asset transactions:
• A N28L first offsets 25G, then N15G.
• A N15L first offsets a N28G, then 25G.
• There can be no net loss in the 25G group since this group contains only gains.
This netting process is summarized as follows:
Section 1231 Gains and Losses from Casualty and Theft
Gains . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Losses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net gain or loss. . . . . . . . . . . . . . . . . . . . . . Possibilities:
1. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Collectibles
Unrecaptured
Depreciation
Other
28%
25%
15%
$x,xxx
(x,xxx)
????
Gains only
– Gain only
N28G
N28G
N28L
N28L
$xx,xxx
(x,xxx)
????
25G
25G
25G
25G
N15G
N15L
N15G
N15L
If the netting process results in a net gain position(s) (e.g., a N28G, N25G, and a N15G) the
net gains from casualties and thefts become § 1231 gains and become part of the second category of other § 1231 transactions (each assigned to either the 28%, 25%, or 15% groups).
Example 3
During the year, T, who is in the 35% tax bracket, reported the following § 1231 gains
and losses from casualties of § 1231 assets (including casualties of capital assets used
in a trade or business) and netted them as shown below.
Section 1231 Gains and Losses
Gains . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Losses. . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net gain or loss. . . . . . . . . . . . . . . . . . . . . .
Netting. . . . . . . . . . . . . . . . . . . . . . . . . . . .
To Section 1231 Other. . . . . . . . . . . . . . . .
Collectibles
Unrecaptured
Depreciation
Other
28%
25%
15%
$10,000
(4,000)
$4,000
—
$ 2,000
(7,000)
$ 6,000
(5,000)
$ 1,000
$4,000
—
$4,000
($ 5,000)
5,000
$ 0
T has a N28G of $1,000 and a N25G of $4,000. Since the end results are net gains, each net
gain is assigned to its appropriate group in the second category of other § 1231 transactions.
Section 1231
If a net loss results, the casualty and theft gains and losses are removed from the § 1231
process and treated separately. The gains are treated as ordinary income, and the losses on
business use assets are deductible for A.G.I. Any other casualty and theft losses are deductible from A.G.I.
2. The second step of the process is to combine any net casualty or theft gains from
the first step with the gains or losses in the second set of § 1231 transactions. In this
regard, the net casualty and theft gains must be assigned to the appropriate group
(15%, 25%, or 28% group) in the second category of § 1231 transactions (sales and
exchanges of § 1231 assets and certain condemnations). For example, if the taxpayer
had a net 15% gain from § 1231 casualties, this gain would become a 15% gain in the
second category of § 1231 transactions. These transactions are then netted just as if
they had been 28%, 25%, or 15% capital gains or losses to determine if there is a net
gain or loss.
3. The final step in the § 1231 netting process is to characterize the gain or loss resulting from
netting the transactions in the second step. If the net result is a loss, the net loss is treated as
an ordinary deduction for A.G.I. It is not treated as a capital loss. If the net result is a gain
(e.g., a N25G and a N15G), these gains are normally treated as capital gains and become
part of the capital gain and loss netting process.
The § 1231 netting process is illustrated in Exhibit 17.1 above and the following examples.
Example 4
During the current year, D sold real estate used in her business for $45,000. She had
purchased the property several years ago for $36,000. D also sold a business car (held
for more than 15 months) at a loss of $1,200. D’s gain on the real estate is computed
as follows:
Selling price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Less: Adjusted basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 45,000
(36,000)
Gain realized and recognized . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 9,000
D nets the gain and loss as follows:
15% Gain from sale of § 1231 asset. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 9,000
15% Loss from sale of § 1231 asset. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,200)
Net 15% § 1231 gain for year. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 7,800
D’s net 15% § 1231 gain of $7,800 is treated as a 15% capital gain. If she had other
capital gains or losses during the year, they will be subject to the capital gain and loss
netting process discussed in Chapter 16.
Example 5
During the year R, a sole proprietor, sold a business computer for $32,000. His basis
at the time of the sale was $44,000. He also sold land used in his business at a gain
of $1,400 and had an uninsured theft loss of works of art used to decorate his business offices (i.e., capital assets held in connection with a trade or business). R had
purchased the artwork for $1,500 and it was valued at $5,000 before the burglary. All
of the assets were acquired more than 12 months ago.
17-9
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Property Transactions: Dispositions of Trade or Business Property
R nets his gains and losses as follows:
Step 1: The net loss from the casualty is $1,500 (adjusted basis). Since R has a
net 15% casualty loss, it is not treated as a § 1231 loss. Instead, the loss is
treated as an ordinary loss (which is fully deductible for A.G.I. since the art
works were business property).
Step 2: Combine gains and losses from sales of § 1231 assets:
15% loss from sale of business computer. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($12,000)
15% gain from sale of business land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,400
Net § 1231 loss for year. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($10,600)
Step 3: A net § 1231 loss is treated as an ordinary deduction. Thus, R’s $10,600 loss
can be used to offset other ordinary income.
Note that the theft loss of the works of art is included in the first step of the netting
process even though these items are capital assets. This loss would have offset, dollar
for dollar, any casualty or theft gains (net of depreciation recapture) from § 1231 assets as well as any casualty or theft gains from other capital assets held in connection
with R’s business. Also note that the current year’s deductible § 1231 loss may result
in a change in the character of any net § 1231 gains in the next five years due to the
look-back rule.
L ook -B ack R ule
For many years, taxpayers took advantage of the § 1231 netting process. For example, assume a taxpayer in the 35 percent tax bracket currently owns two § 1231 assets, both held for
15 months. One asset has a built-in gain of $10,000 and the other has a built-in loss of $9,000.
If both assets are sold during the year, the loss offsets the gain and the taxpayer pays a capital
gain tax of $150 [($10,000 − $9,000 5 $1,000) 3 15%]. If the taxpayer had sold the assets in
different years, the loss would not have reduced the gain, and the tax after both transactions
would have been $1,500 in one year ($10,000 3 15%) and $3,150 ($9,000 3 35%) of savings
in the other year, for a net tax savings of $1,650 ($3,150 − $1,500). As might be imagined,
taxpayers carefully planned their transactions to maximize their tax savings.
In an effort to prevent taxpayers from cleverly timing their § 1231 gains and losses to
ensure that § 1231 losses reduced ordinary income and not potential capital gain, Congress
enacted the so-called look-back rule in 1984. Under this rule, a taxpayer with a net § 1231
gain in the current year must report the gain as ordinary income to the extent of any unrecaptured net § 1231 losses reported in the past five taxable years.18 In recapturing the
§ 1231 gains, recapture occurs in the following order: 28% gains, 25% gains, and 15%
gains. Unrecaptured net § 1231 losses are simply the net § 1231 losses that have occurred
during the past five years that have not been previously recaptured (i.e., the excess of net
§ 1231 losses of the five preceding years over the amount of such loss that has been recaptured in the five prior years).
Example 6
Assume the same facts in Example 5 and that R’s 2012 net § 1231 loss of $10,600
is the only loss he has deducted in the past five years. In 2013 (the current year), R
has a net 15% § 1231 gain of $15,000. R is subject to the look-back rule since in the
prior year he reported a § 1231 loss of $10,600 that has not been recaptured. He must
report $10,600 of ordinary income and $4,400 of net 15% § 1231 gain. Should R have
a § 1231 gain in the following year, he will not be subject to the look-back rule again
since he has recaptured all prior year’s net § 1231 losses.
18
§ 1231(c).
Section 1231
A pplicability
of
L ower R ates
Five potential tax rates apply to long-term capital gains while six rates can apply to ordinary
income, which includes short-term capital gains.
To ensure that the appropriate rate is applied, the following process should be followed.
• The first step is to complete the § 1231 netting process.
• If there is a net § 1231 loss, that loss must be treated as an ordinary loss and it is
left out of the capital gain and loss netting process entirely.
• If there is a net § 1231 gain, it is treated as a long-term capital gain and is entered
into the capital gain and loss netting process in the next step. In order to do this, a
determination must be made as to which part of the gain, if any, is 25% gain, and
which part, if any, is 15% gain.
• Netting of capital gains and losses occurs in each of the various groups of assets.
• Short-term gains are netted against short-term losses and long-term gains are netted against long-term losses.
• Within the long-term netting process, gains and losses are further broken down in
the various sub-groups with 15% gains and losses, and 28% gains and losses being
netted. Since there are no 25% losses, the 25% gains are not reduced.
• The net gains and losses from these three groups are netted against one another as
prescribed in Chapter 16 (e.g., 28% losses are first offset against 25% gains, then
15% gains, and 15% losses are first offset against 28% gains, then 25% gains).
• Short-term gains and losses are netted/combined with long-term gains and losses.
Short-term losses are first netted against 28% gains, then 25% gains, and finally 15%
gains. Net long-term losses are netted against short-term gains.
• The net results are subject to the capital gains tax.
• Short-term gains are treated like ordinary income
• Long-term gains are subject to tax at the appropriate specified capital gains rates
(0%, 10%, 15%, 25%, and 28%)
• Losses are subject to the $3,000 annual limit with the excess being carried forward.
Numerous possibilities exist, therefore, for any net § 1231 gain. Perhaps, the gain would be
offset by capital losses, receiving no favorable treatment at all. However, if the § 1231 gain
survives the netting process to be included in a net capital gain, it is subject to the preferred
rates right along with any other long-term capital gains with surviving unrecaptured § 1250
gain being treated as 25% gain and any other surviving gain treated as 15% gain.
C heck Y our K nowledge
Review Question 1
Indicate whether the following gains and losses are § 1231 gains or losses or capital gains
and losses or neither. Make your determination prior to the § 1231 netting process and assume any holding period requirement has been met.
a. Gain on the sale of General Motors stock held as a temporary investment by
Consolidated Brands Corporation.
b. Gain on the sale of a four-unit apartment complex owned by Lorena Smith. This was
her only rental property.
c. Loss on the sale of welding machinery used by Arco Welding in its business.
d. Loss on theft of welding machinery used by Arco Welding in its business.
e. Gain on sale of diamond bracelet by Nancy Jones.
f. Income from sale of electric razors by Razor Corporation, which manufactures them.
g. Gain on condemnation of land on which Tonya Smith’s personal residence is built.
17-11
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Chapter 17
Property Transactions: Dispositions of Trade or Business Property
h. Gain on condemnation of land owned by Tonya Smith’s business.
i. Loss on sale of personal automobile.
Answer. The § 1231 hodgepodge contains not only gains and losses from § 1231 property
but also those from involuntary conversions by casualty, theft, or condemnation of capital
assets that are used in a trade or business or held as an investment in connection with a trade
or business.
a. The sale of the GM stock is not included in the § 1231 pot since it is a sale of a capital
asset and not an involuntary conversion.
b. The rental property is generally considered property used in a trade or business and
thus § 1231 property even if the owner owns only a single property.
c. The welding machinery is depreciable property used in a business and is therefore
considered § 1231 property.
d. The theft of the welding machinery is also a § 1231 transaction. Note, however, that
in processing the § 1231 gains and losses, the casualties must be segregated from the
sales.
e. The sale of the diamond bracelet produces capital gain since it is a pure capital asset
and not trade or business property.
f. The razors are inventory and are therefore neither capital assets nor § 1231 property.
g. The condemnation of the land near the residence is considered a personal involuntary
conversion gain. Since the land is not held in connection with a trade or business, it
does not qualify as § 1231 property, but it is a capital asset.
h. The condemnation of the land held for business does enter into the § 1231 hodgepodge as a regular § 1231 gain.
i. Although the personal automobile is a capital asset, no loss is allowed from the sale.
Review Question 2
During his senior year at the University of Virginia, Bill decided that he never wanted
to leave Charlottesville. After some thought, he opened his own hamburger joint, Billy’s
Burgers. That was 20 years ago and Bill has had great success, owning a number of businesses all over Virginia and North Carolina. Not believing in corporations, Bill and his wife,
Betty, operate all of these as partnerships.
a. Information from the partnerships and his own personal records revealed the following transactions during the current year:
1. Sale of one of 50 apartment buildings that one of their partnerships owns: $50,000
gain (ignore depreciation)
2. Sale of restaurant equipment: $20,000 loss
Assuming both assets have been held for several years, how should Bill and Betty
report these transactions on their current year return?
Answer. Under § 1231, the taxpayer generally nets gains and losses from the sale of § 1231
property. If a net gain results, the gain is treated as a long-term capital gain, while a net loss
is treated as an ordinary loss. For this purpose, § 1231 property generally includes real or
depreciable property used in a trade or business. In this case, both the apartment complex
and the restaurant equipment are § 1231 property and both are in the 15 percent group.
As a result, the couple should net the gain and loss and report a 15 percent capital gain of
$30,000.
b. The couple’s records for the following year revealed several gains and losses:
1. Office building burned down: $20,000 loss
2. Crane for bungee jumping business stolen: $35,000 gain (assume no depreciation
had been claimed)
3. Parking lot sold: $14,000 loss
4. Exxon stock sold: long-term capital loss of $10,000
5. Condemnation of Greensboro land held for use in the business: $15,000 gain.
Depreciation Recapture
Assuming each of the assets was held for several years, determine how much 15
percent capital gain or loss as well as the amount of ordinary income or loss that
Bill and Betty will report for the year.
Answer. The § 1231 netting process requires the taxpayer to separate § 1231 casualty gains
and losses from other § 1231 transactions (sometimes referred to as regular § 1231 items).
The casualty loss on the office building and the casualty gain on the crane are both considered § 1231 15 percent casualties since they involve § 1231 property (i.e., real or depreciable
property used in business). Note that the condemnation—even though it is an involuntary
conversion—is not treated as a § 1231 casualty. The casualty items are netted to determine
whether there is a net gain or loss. Here, there is a net casualty 15 percent gain of $15,000
($35,000 − $20,000). This net gain is then combined with any “regular” § 1231 items, in
this case the $14,000 loss on the sale of the parking lot (real property used in a business) and
the $15,000 gain on the condemnation of the land (a capital asset). Note that both “regular”
§ 1231 items are also in the 15 percent group. After netting these items, the partnership has
a net gain of $16,000. This $16,000 net § 1231 gain is treated as a 15 percent capital gain
and is combined with $10,000 15 percent capital loss on the sale of the stock. The end result
is a $6,000 15 percent capital gain. This process can be summarized as follows (see also
Exhibit 17.3):
c. Same as in (b), except Bill and Betty reported a net § 1231 loss of $3,000 in the previous year.
Answer. In this case, the look-back rule applies, causing $3,000 of the net 15 percent § 1231
gain to be treated as ordinary income. As a result, the couple’s 15 percent capital gain from
the § 1231 netting process is $13,000 and their net 15 percent capital gain is only $3,000.
Depreciation Recapture
H istorical P erspective
For many years, taxpayers have taken advantage of the interaction of § 1231 and the depreciation rules to secure significant tax savings. Prior to 1962 there were no substantial
statutory restrictions on the depreciation methods that could be adopted. Consequently, a
taxpayer could quickly recover the basis of a depreciable asset by selecting a rapid depreciation method such as declining balance and using a short useful life. If the property’s value
did not decline as quickly as its basis was being reduced by depreciation deductions, a gain
was ensured if the property was disposed of at a later date. The end result could be quite
beneficial.
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Chapter 17
Property Transactions: Dispositions of Trade or Business Property
Example 7
During the current year, T purchased equipment for $1 million. After two years, T, using favorable depreciation rules, had claimed and deducted $600,000 of depreciation,
leaving a basis of $400,000. Assume that the property did not truly depreciate in value
and T was able to sell it in the third year for its original cost of $1 million. In such
case T would report a gain of $600,000 ($1,000,000 − $400,000). Except for time
value of money considerations, it appears that the $600,000 gain and the $600,000 of
depreciation are simply a wash. However, the depreciation reduced ordinary income
that would be taxed at ordinary rates while the gain would be a § 1231 gain and likely
taxed at capital gain rates. As an illustration of the savings that could be achieved,
assume that the law at this time provided for a top capital gain rate of 20% and the
taxpayer’s ordinary income was taxed at a 40% rate. In this case the depreciation
would offset ordinary income and provide tax savings of $240,000, but the $600,000
gain on the sale would be treated as a capital gain and produce a tax of only $120,000.
Thus, even though the taxpayer has had no economic gain or loss with respect to the
property—he bought and sold the equipment for $1,000,000—he was able to secure a
tax benefit of $120,000 ($240,000 − $120,000).
LO.4
Explain the purpose
of the depreciation
recapture rules.
The above example clearly illustrates how taxpayers used rapid depreciation and the favorable treatment of § 1231 gains to effectively convert ordinary income into capital gain.
In fact, this strategy—deferring taxes with quick depreciation write-offs at ordinary rates
and giving them back later at capital gains rates—was the foundation of many tax shelter
schemes.
Legislation to limit these benefits came in a number of forms, but the most important
was the enactment of the so-called depreciation recapture rules. These rules strike right at
the heart of the problem, generally treating all or some portion of any gain recognized as ordinary income, based on the amount of depreciation previously deducted. Thus, in the above
example, the taxpayer’s $600,000 gain, which was initially characterized as a § 1231 gain,
is treated as ordinary income because of the $600,000 of depreciation previously claimed.
In this way, all of the tax savings initially given away by virtue of the ordinary depreciation
deductions are recaptured. In this regard, it may be useful to think of a gain as consisting of
two parts: the gain attributable to depreciation and the gain attributable to holding the asset
(resulting from appreciation and inflation). “Depreciation gains” normally are treated as
ordinary income while “holding gains” are § 1231 gains and potentially taxed as long-term
capital gains. Unfortunately, much like § 1231 in general, the recapture rules can become
quite complex. The operations of the specific provisions are discussed below.
W hen A pplicable
Before specific recapture rules are examined, there are two very important points to keep in
mind. First, depreciable assets held for one year or less do not qualify for § 1231 treatment.
Thus, any gain from the disposition of such assets is always reported as ordinary income.
Second, the depreciation recapture rules do not apply if property is disposed of at a loss.
Remember that losses from the sale or exchange of depreciable assets are treated as § 1231
losses if the property is held more than a year. In addition, casualty or theft losses of such
property are included in the § 1231 netting process. Any loss from a depreciable asset held
one year or less is an ordinary loss regardless of whether it was sold, exchanged, stolen, or
destroyed.
T ypes
of
D epreciation R ecapture
There are essentially three depreciation recapture provisions in the Code. These are:
1. Section 1245 Recapture—commonly called the full recapture rule, and applicable
primarily to depreciable personalty (rather than realty)
17-15
Depreciation Recapture
2. Section 1250 Recapture—commonly called the partial recapture rule, and applicable
to most depreciable realty if a method of depreciation other than straight-line was
used
3. Section 291 Recapture—commonly called the additional recapture rule, and applicable
only to corporate taxpayers
These depreciation recapture provisions affect the character—not the amount—of the gain.
Losses are not affected. Each of these recapture rules is discussed below.
F ull R ecapture —§ 1245
The recapture concept was first introduced with the enactment of § 1245 by the Revenue
Act of 1962. Section 1245 generally requires any gain recognized to be reported as ordinary
income to the extent of any depreciation allowed on § 1245 property after 1961.
Definition of § 1245 Property
The recapture of depreciation under § 1245 applies only to § 1245 property, normally depreciable personal property.19 Because the definition of personal property itself is so broad,
§ 1245 generally covers a wide variety of depreciable assets such as:
• Machinery and equipment used in production of goods and services
• Office furniture and equipment
• Automobiles, vans, trucks, and other transportation equipment
• Livestock used for breeding or production
• Intangibles such as patents, copyrights, trademarks, and goodwill that have been amortized under § 197 or otherwise.
Essentially the amortization is treated the same as depreciation, just like any portion of
the cost of a depreciable asset that is expensed under § 179 is treated as depreciation allowed.20 It is important to understand that § 1245 applies only if the property is depreciable
or amortizable. Consequently, it pertains only to property that is used in a trade or business
and property held for the production of income. For example, livestock that are considered
inventory are not subject to depreciation and are therefore not § 1245 property, although any
gain or loss from the disposition of inventory is ordinary income.
Although the above definition is usually sufficient, § 1245 property actually includes a
number of other assets besides depreciable personalty, including the following:21
1. Property used as an integral part of manufacturing, production, or extraction, or in
furnishing transportation, communications, electrical energy, gas, water, or sewage
disposal services.
a. However, any portion of a building or its structural components is not included.
b. A research facility or a facility for the bulk storage of commodities related to an
activity listed above is included.
2. A single-purpose agricultural or horticultural structure (e.g., greenhouses).
3. A storage structure used in connection with the distribution of petroleum or any primary product of petroleum (e.g., oil tank).
4. Any railroad grading or tunnel bore.
5. Certain other property that is subject to a special provision allowing current deductibility
or rapid amortization (e.g., pollution control facilities and railroad rolling stock).
19
§ 1245(a)(3).
20
ee § 197(f)(7) for intangibles and § 1245(a)(3)(D) for
S
expensed property and certain other properties subject to
unique expensing rules.
21
he definition parallels that of § 38 property, which qualified
T
for the investment tax credit. § 48(a)(1).
LO.5
Compute depreciation
recapture under § 1245.
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Chapter 17
Property Transactions: Dispositions of Trade or Business Property
Operation of § 1245
Section 1245 generally requires any gain recognized to be treated as ordinary income to
the extent of any depreciation allowed.22 To state the rule in another way: any gain on the
disposition of § 1245 property is ordinary income to the extent of the lesser of the gain recognized or the § 1245 recapture potential, generally the depreciation claimed and deducted.
Although both statements say the same thing, the latter helps focus attention on two points
and eliminates some misconceptions. First, a taxpayer is never required to report more
income than the amount of gain realized regardless of the amount of depreciation claimed
and deducted (i.e., regardless of the amount of recapture potential). For example, if the
taxpayer realizes a gain of $10,000 and has deducted depreciation of $15,000, the taxpayer
reports only $10,000 of income, all of which would be ordinary. Note that the depreciation
recapture rules do not affect the amount of gain or loss, only the character of any gain to be
recognized. Second, using the term recapture potential helps emphasize that sometimes the
amount that must be recaptured may include more than mere depreciation.
Section 1245 recapture potential includes all depreciation or amortization allowed (or
allowable) with respect to a given property—regardless of the method of depreciation used.
This is why § 1245 is often called the full recapture rule. Recapture potential also includes
adjustments to basis related to items that are expensed (e.g., under § 179 expense election)
or where tax credits have been allowed under various sections of the Code.23
To summarize, determining the character of gain on the disposition of § 1245 property
is generally a three-step process:
1. Determine the amount of gain to be recognized, if any.
2. The gain is ordinary income to the extent of the lesser of the gain recognized or the
§ 1245 recapture potential (all depreciation allowed or allowable).
3. Any recognized gain in excess of the recapture potential retains its original character, usually § 1231 gain.
Recall that there is no § 1245 depreciation recapture when a property is sold at a loss, so any
loss is normally a § 1231 loss.
Example 8
T owned a printing press that he used in his business. Its cost was $6,800 and T
deducted depreciation in the amount of $3,200 during the three years he owned the
press. T sold the press for $4,000 and his realized and recognized gain is $400 ($4,000
sales price − $3,600 adjusted basis). T’s recapture potential is $3,200, the amount
of depreciation taken on the property. Thus, the entire $400 gain is ordinary income
under § 1245.
Example 9
Assume the same facts as in Example 8, except that T sold his press for $7,000. In
this case, T’s realized and recognized gain would be $3,400 ($7,000 − $3,600). The
ordinary income portion under § 1245 would be $3,200 (the amount of the recapture
potential), and the remaining $200 of the gain is a § 1231 gain. Note that in order for
any § 1231 gain to occur, the property must be sold for more than its original cost
since all of the depreciation is treated as ordinary income.
22
§ 1245(a).
23
ee § 1245(a)(2) for a listing of these adjustments and their
S
related Code sections, including the basis adjustment related
to the earned portion of any investment credit.
17-17
Depreciation Recapture
Example 10
Assume the same facts as in Example 8, except that the printing press is sold for
$3,000 instead of $4,000. In this case, T has a loss from the sale of $600 ($3,000 −
$3,600 adjusted basis). Because there is a loss, there is no depreciation recapture. All
of T’s loss is a § 1231 loss.
Exceptions and Limitations
In many ways, § 1245 operates much like the proverbial troll under the bridge. It sits ready
to spring on its victim whenever the proper moment arises. Section 1245 generally applies
whenever there is a transfer of property. However, § 1245 does identify certain situations
where it does not apply, most of which are nontaxable events. For example, there is no recapture on a transfer by gift or bequest since both of these are nontaxable transfers.24
In involuntary conversions and like-kind exchanges, the depreciation recapture under
§ 1245 is limited to the gain recognized.25 Similarly, in nontaxable business adjustments
such as the formation of partnerships, transfers to controlled corporations, and certain corporate reorganizations, § 1245 recapture is limited to the gain recognized under the controlling provisions.26 In any situation where recapture is not triggered, it is generally not lost
but carried over in some fashion.
P artial R ecapture —§ 1250
As originally enacted in 1961, the concept of recapture as set forth in § 1245 generally applied only to personalty. Gains derived from dealing in realty were not subject to recapture.
In 1963, however, Congress eliminated this omission by enacting § 1250, a special recapture
provision that applied to most buildings. Since 1963, § 1245 has generally been associated
with depreciation recapture for personal property while § 1250 served that role for buildings. Although the two provisions are similar, § 1250 is far less damaging. Specifically,
§ 1250 calls for the recapture of only a portion of any accelerated depreciation allowed with
respect to § 1250 property. Note that while §§ 1250 and 1245 are essentially the same—
they both convert potential capital gain into ordinary income—§ 1250 differs from § 1245
in several important ways: (1) it applies only if an accelerated method is used; (2) it does
not require recapture of all the depreciation deducted but only a portion—generally only
the excess of accelerated depreciation over what straight-line would have been; and (3) it
applies to a different type of property, buildings and their components, rather than personal
property. These basic concepts are illustrated in the following example and discussed further below.
Example 11
T purchased an office building in 1979 for $600,000. In 1979, depreciation generally was computed using either the straight-line or accelerated method based on the
estimated useful life of the property and estimated salvage value, all determined by
the taxpayer. T depreciated the building over its estimated useful life of 40 years,
using an accelerated method and no salvage value. This year, T sold the building
for $900,000. At the time of sale, accelerated depreciation actually deducted was
$500,000. Straight-line depreciation using the same facts would have been $300,000.
The building is § 1250 property since it is realty acquired after 1969. As determined
below, T recognizes a gain of $800,000, $200,000 is recaptured as ordinary income
under § 1250 and the $600,000 balance is § 1231 gain.
§§ 1245(b)(1) and (2). Recapture of depreciation under
§ 1245 is required, however, to the extent § 691 applies
(relating to income in respect to a decedent).
24
25
§ 1245(b)(4).
26
§ 1245(b)(3). See Chapter 19 for further discussion of
nontaxable business adjustments.
LO.6
Compute depreciation
recapture under
§ 1250.
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Chapter 17
Property Transactions: Dispositions of Trade or Business Property
Amount realized . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $900,000*
Adjusted basis
Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $600,000
Depreciation (accelerated) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (500,000)
Adjusted basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (100,000)
Gain on sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Depreciation recapture under § 1250
Accelerated depreciation actually deducted . . . . . . . . . . . . . . . . . . . . . . . . $500,000
Hypothetical straight-line depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . (300,000)
$ 800,000
Section 1250 recapture reported as ordinary income . . . . . . . . . . . . . . . . . Section 1231 gain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 200,000
$ 600,000
* A separate allocation and calculation would be required to determine any gain or loss on the land and is ignored here for
simplicity.
Note that under the partial recapture rule of § 1250 only the excess of the actual
amount of accelerated depreciation deducted ($500,000) over what the straight-line
depreciation would have been ($300,000), a difference of $200,000, is recaptured.
This excess is treated as ordinary income. Had the property been § 1245 property, all
$500,000 would have been recaptured. Also observe that under § 1250 none of the
straight-line depreciation, $300,000 is recaptured. However, this unrecaptured depreciation on § 1250 property is taxed at a maximum rate of 25% as discussed below.
As noted in the example, § 1250 does not recapture the straight-line depreciation. In enacting § 1250 Congress wanted to ensure that ordinary income treatment would be applied only
to what were truly excess depreciation deductions. Gain not attributable to excess depreciation was considered attributable to a rise in price levels and was eligible for relief provided
for capital gains and not subject to recapture.
Section 1250 Property
Section 1250 property is generally any real property that is depreciable and is not covered
by § 1245.27 For the most part, § 1250 applies to all of the common forms of real estate such
as office buildings, warehouses, apartment complexes, and low-income housing. As a practical matter, sales of these properties rarely produce recapture because the law has required
the straight-line method for depreciation since 1986. However, Section 1250 property also
includes 15- and 20-year realty which is depreciated using the 150 percent declining balance
and, therefore, is capable of creating excess depreciation. This category includes such assets
as multi-purpose agricultural structures (e.g., barns), land improvements (roads, sidewalks,
fences, landscaping, shrubbery, docks), gas stations, convenience stores and more. As explained earlier, nonresidential real estate (e.g., warehouses and office buildings) placed in
service after 1980 and before 1987 for which an accelerated method was used is covered by
the full recapture rule of § 1245.28
Depreciation of Real Property
Section 1250 applies only if an accelerated method of depreciation is used. If the straightline depreciation method is used, § 1250 does not apply and there is no depreciation
recapture for noncorporate taxpayers.29 For this reason, a critical first step in determining
the relevance of § 1250 is determining how the taxpayer has depreciated the realty.
Realty Placed in Service before 1987. Prior to 1987, taxpayers could choose to
use either an accelerated or straight-line method to compute depreciation for realty. This was
an extremely important decision. It affected not only the amount of depreciation the taxpayer
claimed but also the character of any gain on a subsequent disposition of the property. For
example, a taxpayer could accelerate depreciation deductions but only at the possible expense
27
§ 1250(c).
28
I t is important to note, however, that such properties are
§ 1250 property if the optional straight-line method is used.
§ 1245(a)(5).
29
As explained within, corporate taxpayers are still required to
recapture 20 percent of any straight-line depreciation under
§ 291. Also, any unrecaptured straight-line depreciation is
taxed at a maximum rate of 25 percent.
Depreciation Recapture
of recapture. Alternatively, the taxpayer could accept the slower-paced straight-line method
and avoid the § 1250 recapture rules. But the Tax Reform Act of 1986 ended this flexibility
and at the same time simplified the law. Taxpayers who place realty in service after 1986 must
use the straight-line method for residential and nonresidential realty. As a result, the recapture rules of § 1250 do not apply to residential and nonresidential realty acquired after 1986.
However, much of the existing inventory of real property was acquired before 1987 and may
therefore be subject to § 1250, depending on the depreciation method used.
Realty Placed in Service from 1981 through 1986. For real property acquired
between the beginning of 1981 and the end of 1986, the taxpayer could either use the accelerated depreciation method allowed under ACRS or elect an optional straight-line method.
In most cases, a taxpayer would select the accelerated method. If an accelerated method is
used for residential realty acquired during 1981 through 1986, § 1250 applies, requiring
recapture of the excess depreciation. However, as noted earlier, if an accelerated method is
used for nonresidential realty acquired during 1981 through 1986, the property is considered § 1245 and the full recapture rule applies.
By the close of 2005, realty acquired during 1981 through 1986 became fully depreciated since the lives were 15, 18 or 19 years during this time. As a result, there is no § 1250
recapture for residential realty since there is no excess depreciation (i.e., total accelerated depreciation would be identical to total straight-line depreciation). Similarly, there is no § 1250
recapture for nonresidential realty if the straight-line method was used. However, to reiterate,
if the accelerated method was used in depreciating nonresidential realty acquired during these
tainted years, 1981–1986, § 1245 applies and all of the accelerated depreciation is recaptured.
Realty Placed in Service before 1981. All depreciable real property acquired
before 1981 is classified as § 1250 property. For such property acquired before 1981 (nonACRS property), taxpayers were required to estimate useful lives and salvage values.
Although various methods could be used, there were restrictions.30 In those situations where
an accelerated method was used, § 1250 applies subject to certain limitations. As discussed
further below, none of the excess depreciation produced by realty for years after 1963 and
before 1970 is subject to recapture. In the case of low-income housing and other residential
real estate, excess depreciation resulting after 1969 and before 1976 is no longer recaptured.
After 1975, excess depreciation on low-income housing is exempt from recapture if the
property is held more than 16 2/3 years.
Summary of § 1250 Application
The significance of § 1250 has declined considerably over the years. Subject to certain unusual situations (e.g., certain low-income housing, certain Liberty Zone property, etc.), the
following general observations can be made about the current status of § 1250:
• For residential and nonresidential realty acquired after 1986, there is no § 1250
• recapture because the straight-line method must be used for such property and no excess depreciation results.
• For residential realty acquired during 1981–1986 there is no § 1250 recapture since
these assets are fully depreciated and there is no excess depreciation.
• For nonresidential realty acquired during 1981–1986 for which the straight-line
method was used, there is no recapture under § 1250, but § 1245 requires full-recapture
if an accelerated method was used for the property.
• The reach of § 1250 is usually limited to realty acquired during 1970–1980. And much
of this property, which at this point is 27–37 years old, has turned over and in the hands
of the new buyer § 1250 does not apply.
Although the traditional recapture rules of § 1250 may not apply, gains on § 1250 property
are not guaranteed the benefits of favorable capital gain rates. As explained further below,
such gains may be taxed at a rate of up to 25 percent to the extent of any unrecaptured
straight-line depreciation.
30
§ 167(j).
17-19
17-20
Chapter 17
Property Transactions: Dispositions of Trade or Business Property
Operation of § 1250
The two critical factors in determining the amount, if any, of § 1250 recapture are the gain
realized and the amount of excess depreciation. Excess depreciation refers to depreciation
deductions in excess of that which would be deductible using the straight-line method. For
property held one year or less, all depreciation is considered excess depreciation.31
As a general rule, § 1250 requires recapture of the excess depreciation, that is, the
excess of accelerated over straight-line. Consequently, even if the taxpayer uses an accelerated method to compute the amount of depreciation deducted on the return, the hypothetical
amount of straight-line depreciation must still be computed in order to determine the excess
of accelerated over straight-line when the property is sold. In determining the hypothetical
amount of straight-line depreciation, the taxpayer uses the same life and salvage value, if
any, that were used in computing accelerated depreciation.32 Because of this approach, a
taxpayer who uses the straight-line method would have no excess depreciation and no recapture. Because the § 1250 recapture rule applies only to any excess depreciation claimed
by a taxpayer, it is sometimes referred to as the partial recapture rule. However, it should be
emphasized that beginning in 1997, the unrecaptured § 1250 depreciation (e.g., the straightline depreciation) on § 1250 property held more than 12 months is subject to a special
25 percent tax rate (assuming it survives the § 1231 netting process).
Determining the taxation of any gain recognized on the disposition of § 1250 property
is a four-step process:
1. Determine the amount of gain to be recognized, if any.
2. The gain is ordinary income to the extent of the lesser of the gain recognized or the
§ 1250 recapture potential (generally the excess depreciation allowed).33
3. Any recognized gain in excess of the recapture potential is usually treated as § 1231
gain.
4. Any gain recognized on § 1250 property held more than 12 months that is due to depreciation that is not recaptured and which survives the applicable netting processes is taxed at a
maximum rate of 25 percent to the extent of any unrecaptured depreciation. Any additional
gain is generally 15 percent gain.
Two other considerations should be noted. If § 1250 property is held for a year or less, all
depreciation (not just the excess) is recaptured.34 In addition, there is no § 1250 depreciation
recapture when a property is sold at a loss, so any loss is normally a § 1231 loss.
Unrecaptured § 1250 Gain
As may be apparent from step 3 above, under § 1250, taxpayers are required to recapture
depreciation only if an accelerated method is used to depreciate the property. Consequently,
individual taxpayers never recapture depreciation on § 1250 property if the method is used.
Without some special rule, any gain attributable to straight-line depreciation for § 1250
property held more than 12 months would normally qualify for taxation at a 15 percent rate.
Congress felt this treatment was too generous and created a special rule for unrecaptured
§ 1250 gain. The unrecaptured § 1250 gain is the lesser of (1) the gain recognized, or (2)
the depreciation allowed after each (the gain recognized and the depreciation allowed) is
reduced by any § 1250 recapture. The resulting amount will equal the amount of straightline depreciation that was claimed or would have been claimed had the straight-line method
been used (or, if less, the gain recognized minus the § 1250 recapture).
31
§ 250(b).
32
§ 1250(b)(5).
33
ee § 1250(a) and discussion following dealing with
S
recapture of only a portion of the excess depreciation for
certain properties.
34
§ 1250(b)(1).
Depreciation Recapture
17-21
Example 12
About 10 years ago, F purchased some residential rental property for $100,000. This
year he sold the property for $110,000. He had claimed straight-line depreciation
of $30,000 over this time, resulting in a basis of $70,000 (do not attempt to verify this amount). As a result, F recognized a gain of $40,000. Since the property
is realty and a straight-line depreciation method was used there is no § 1250 recapture. Consequently, the entire gain is a § 1231 gain. However, the § 1231 gain
will be treated as a 25% gain to the extent of any straight-line depreciation claimed.
Therefore, $30,000 of the gain is a 25% § 1231 gain while $10,000 is a 15% § 1231
gain (i.e., in the capital gain netting process these will be 15% and 25% long-term
gains, respectively). If F had sold the property for $90,000, he would have had a gain
of $20,000, all of which would have been a 25% gain (i.e., the lesser of the gain realized, $20,000, or the unrecaptured straight-line depreciation, $30,000).
Example 13
Same facts and $110,000 sales price from Example 12 above, except that F also has
a $400 gain on the sale of K Corporation stock held 26 months. F is single and has
taxable income, excluding these transactions, of $90,000. F’s tax would be computed
as follows (using the 2013 tax rates for single taxpayers):
Regular tax on $90,000:
Tax on $87,850. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $17,891
Tax on excess at 15%
[($90,000 − $87,850 5 $2,150) 3 28%] . . . . . . . . . . . . . . . . . . . . . . . 602
$18,493
Tax on 15% gains (15% 3 $10,400). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,560
Tax on 25% gains (25% 3 $30,000). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,500
Total tax. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $27,553
Combined Results
The net gain from the disposition of § 1250 property can be treated as ordinary income
subject to the regular tax rate, 15 percent capital gain, and/or 25 percent capital gain (and
rarely 28 percent capital gain). Each step in the netting and tax calculation processes has
been covered. Examples 14 through 17 and Comprehensive Example 19 illustrate how they
work in combination.
Example 14
During the current year, L sold a small office building for $38,000. The building
cost $22,000 in 1980, and she had deducted depreciation of $12,000 using an accelerated method ($10,000 was assigned to the land and was not depreciable).
Straight-line depreciation would have been $10,600. L’s gain recognized on the sale is
$28,000 ($38,000 amount realized − $10,000 adjusted basis). Of that amount, $1,400
($12,000 − $10,600 5 $1,400 excess depreciation) is ordinary income under § 1250
and the remainder, $26,600, is § 1231 gain. Of the $26,600 § 1231 gain, the unrecaptured depreciation of $10,600 ($12,000 − $1,400) is a 25% gain. The $16,000 excess
of the amount realized over the original basis is 15% gain.
17-22
Chapter 17
Property Transactions: Dispositions of Trade or Business Property
Example 15
M purchased a rental duplex during 1986 for $60,000 (not including any value assigned to land). He deducted $60,000 depreciation using the 19-year realty ACRS
tables. Depreciation using the straight-line recovery percentages for 19-year realty
would have resulted in total depreciation of $60,000 (the duplex is fully depreciated
under each method). This year on May 3 M sold the property for $87,000. His gain is
reported as follows:
Sales price. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 87,000
Less: Adjusted basis
Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $60,000
Depreciation allowed. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (60,000) (-0-)
Gain to be recognized. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 87,000
Accelerated depreciation claimed and deducted. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 60,000
Straight-line depreciation (hypothetical). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (60,000)
Excess depreciation subject to recapture. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $
-0-
Character of gain:
Ordinary income (partial recapture). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $
-0 § 1231 gain subject to 25% rate. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000
§ 1231 gain subject to 15% rate. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27,000
Total gain recognized. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 87,000
First, observe that the property is residential property (rather than nonresidential
property) so it is subject to §1250 that requires recapture of the excess of accelerated
depreciation over straight line. In this case, however, there is no excess depreciation
since the rental property is fully depreciated. Thus, without a special rule, the gain not
recaptured under § 1250 might be subject to the 15% capital gains rate. However, the
depreciation that has not been recaptured, $60,000, is carved out and is considered a
25% § 1231 gain. Also observe that the $60,000 of 25% § 1231 gain is the amount
of straight-line depreciation. The remaining gain (i.e., the amount above the original
cost) of $27,000 is a 15% § 1231 gain.
Example 16
Assume the same facts as in Example 15, except that M elected to recover his basis in
the duplex using the 19-year straight-line method. Consequently she still recognizes
gain of $87,000 computed as follows:
Sales price. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 87,000
Less: Adjusted basis
Cost. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $60,000
Depreciation (straight-line). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (60,000)
(-0-)
Gain. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(87,000)
None of the gain is subject to § 1250 recapture since M used straight-line depreciation
(a requirement after 1986). However, the amount representing the unrecaptured depreciation (i.e., the straight-line depreciation) of $60,000 is considered a 25% § 1231
gain and the $27,000 balance is considered a 15% § 1231 gain.
Depreciation Recapture
Example 17
Assume the same facts as in Example 15, except that the property is an office building
rather than a duplex. In this case, because the property is nonresidential real property
and the accelerated method was used, the asset is treated as § 1245 property rather
than § 1250 property. Thus, M is subject to full rather than partial depreciation recapture. All of the $60,000 depreciation is recaptured and treated as ordinary income.
The balance of the gain, $27,000 is treated as a 15% § 1231 gain.
History of § 1250
Over the years, § 1250 has been changed frequently, with a general trend toward an expanded
scope. The rules explained above apply only to depreciation allowed on nonresidential property after 1969 and residential property (other than low-income housing) after 1975. Only
a portion of any other excess depreciation on § 1250 property is included in the recapture
potential. The following percentages are applied to the gain realized in the transaction or the
excess depreciation taken during the particular period, whichever is less:
1. For all excess depreciation taken after 1963 and before 1970, 100 percent less 1 percent for each full month over 20 months the property is held.35 Any sales after 1979
would result in no recapture of pre-1970 excess depreciation since this percentage,
when calculated, is zero.
2. For all excess depreciation taken after 1969 and before 1976, as follows:
a. In the case of low-income housing, 100 percent less 1 percent for each full month
the property is held over 20 months.
b. In the case of other residential rental property (e.g., an apartment building) and
property that has been rehabilitated [for purposes of § 167(k)], 100 percent less 1
percent for each full month the property is held over 100 months.36
All sales from this group of real property after August 1992 will have no recapture of excess
depreciation claimed before 1976.
3. For excess depreciation taken after 1975 on low-income housing and property that has
been rehabilitated [for purposes of § 167(k)], 100 percent less 1 percent for each full
month the property is held over 100 months.37
In summary, 100 percent of the excess depreciation allowed with respect to § 1250 property
after 1975 is subject to recapture unless it falls into one of the above categories. Any gain
recognized to the extent of any unrecaptured depreciation will be considered 25% gain. The
rules for the various categories are set forth in § 1250(a).
Exceptions and Limitations under § 1250
Generally, the exceptions and limitations that apply under § 1245 also apply under § 1250.
Thus, gifts, inheritances, and most nontaxable exchanges are allowed to occur without triggering recapture.38 This exception is extended to any property to the extent it qualifies as
a principal residence and is subject to deferral of gain under § 1034 or nonrecognition of
gain under § 121.39 In such nontaxable exchanges, the excess depreciation (that is not recaptured) taken prior to the nontaxable exchange on the property transferred carries over
to the property received or purchased.40 Similarly, in the case of gifts and certain nontaxable
transfers in which the property is transferred to a new owner with a carryover basis, the excess
depreciation carries over to the new owner.41 In the case of inheritances in which basis to
35
§ 1250(a)(3).
38
§§ 1250(d)(1) through (d)(4).
36
§ 1250(a)(2).
39
§ 1250(d)(7).
37
§ 1250(a)(1).
40
Reg. §§ 1.1250-3(d)(5) and (h)(4).
17-23
17-24
Chapter 17
Property Transactions: Dispositions of Trade or Business Property
the successor in interest is determined under § 1014, no carryover of excess depreciation
occurs.42
Certain like-kind exchanges and involuntary conversions may result in the recognition of gain solely because of § 1250 if insufficient § 1250 property is acquired. Since not
all real property is depreciable, it is possible that the replacement property would not be
§ 1250 property and would still qualify for nonrecognition under the appropriate rules of
§§ 1033 or 1034. In such situations, gain will be recognized to the extent the amount that
would be recaptured exceeds the fair market value of the § 1250 property received (property
purchased in the case of an involuntary conversion).43
Example 18
D completed a like-kind exchange in the current year in which he transferred an
apartment complex (§ 1250 property) for rural farmland (not § 1250 property). The
apartment had cost D $175,000 in 1980 and depreciation of $89,000 has been taken
under the 200% declining-balance method. D would have deducted $62,000 under the
straight-line method.
The farm land was worth $200,000 at the time of the exchange. There were no
improvements on the farm property. D’s realized gain on the exchange is $114,000
($200,000 amount realized − $86,000 adjusted basis in property given up). If there
had been no § 1250 recapture, then D would have had no recognized gain. Because
the property acquired was not § 1250 property, § 1250 supersedes (overrides) § 1031.
D has a recognized gain of $27,000 [($89,000 − $62,000), the amount of excess depreciation], which is all ordinary income under § 1250.
Exhibit 17.2 provides an overview of the handling of sales and exchanges of business
property. Exhibit 17.3 provides a chart that may be useful in summarizing property transactions. Note that for purposes of this Exhibit 17.3, no distinction is made between 15%, 25%
and 28% § 1231 gains and losses or 15%, 25% and 28% capital gains and losses. A comprehensive example of sales and exchanges of trade or business property is presented below.
EXHIBIT 17.2
Stepwise Approach to Sales or Exchange of
Trade or Business Property—An Overview
Step 1:Determine the amount of gain to be recognized, if any. There is no recapture in the case of losses.
Step 2:Calculate any depreciation recapture on the disposition of § 1245 property and § 1250 property
sold or exchanged at a taxable gain during the year.
Step 3: F or any remaining gain (after recapture) on depreciable property held for more than one year, add
to other § 1231 gains and losses and complete the § 1231 netting process.
• The § 1231 gain must be broken down into the portions that qualify as 15%CG and 25%CG
(and rarely 28%CG).
Step 4:Complete the netting process for capital assets, taking into consideration the net § 1231 gain,
if any.
• The § 1231 gain is combined with other long-term capital gains and losses (with separate
netting for 15%CG, 25%CG, and 28%CG. Then the long-term capital gain or loss is combined
with the short-term capital gain or loss.
41
Reg. §§ 1.1250-3(a), (c), and (f).
42
Reg. § 1.1250-3(b).
43
§ 1250(d)(4)(C). A similar rule is provided for rollovers
(deferral) of gains from low-income housing under § 1039
[see § 1250(d)(8)].
Depreciation Recapture
EXHIBIT 17.3
Summary of Property Transactions
17-25
17-26
Chapter 17
Property Transactions: Dispositions of Trade or Business Property
Example 19
Ted and Carol Smith sold the following assets during the current year:
Description
Land and building
(straight-line depreciation)
Cost, $13,000
Depreciation allowed, $4,000
Photocopier
Cost, $2,500
Depreciation allowed, $500
Business auto
Cost, $4,000
Depreciation allowed, $2,080
Holding Period
Selling Price
Adjusted Basis
Recognized
Gain (Loss)
3 years
$14,000
$9,000
$5,000
14 months
2,600
2,000
600
2 years
1,800
1,920
(120)
In determining the tax consequences of these sales, the Smiths must start with gains
and losses from § 1231 transactions. The ultimate treatment of the gains, the character
of the gain and any possible depreciation recapture must be considered.
• On the sale of the land and the building, there is no depreciation recapture for
the building since straight-line depreciation was used. However, there is unrecaptured depreciation of $4,000 which is accounted for as a 25% § 1231 gain.
The balance of the gain on the land and building, $1,000, is a 15% § 1231 gain.
• On the sale of the photocopier, $500 of the § 1231 gain of $600 is recaptured
under § 1245 and treated as ordinary income. The balance of the gain, $100, is
a 15% § 1231 gain.
• On the sale of the automobile, there is no recapture since it is sold at a loss. The
$120 loss is treated as a 15% § 1231 loss. This information is summarized below.
Section 1231 Gains and Losses
Collectibles
Unrecaptured
Depreciation
Other
28%
25%
15%
$4,000
$1,000
100
(120)
Land and building. . . . . . . . . . . . . . . Photocopier . . . . . . . . . . . . . . . . . . . Automobile. . . . . . . . . . . . . . . . . . . . Capital gains from § 1231 . . . . . . . . $0
$4,000
$ 980
In this situation, the Smiths net the various groups, resulting in net gains in each of
the groups as shown above. These amounts are then combined with the appropriate
capital gain groups to determine the final treatment. Note that if the Smiths had unrecaptured § 1231 losses, they would first offset the 28% gains, then 25% gains, and
finally 15% gains. The information is summarized in Exhibit 17.3.
Depreciation Recapture
17-27
Example 20
Assume that the Smiths, from the previous example, had the following capital asset
transactions during the same year:
Holding
Period
Selling
Price
4 months
3 years
5 years
$ 3,200
3,200
12,000
Description
100 shares XY Corp.
100 shares GB Corp.
1 acre vacant land
Adjusted
Basis
Description of
Gain or (Loss)
$4,200
4,600
5,000
$(1,000) STCL
(1,400) LTCL
7,000 LTCG
Taking into consideration the § 1231 gains from Example 19, the Smith’s summarize
their transactions as follows.
Short-Term
Capital Gains and Losses
Ordinary
Capital gains from § 1231 . . . . XY stock loss. . . . . . . . . . . . . . . GB stock loss . . . . . . . . . . . . . . Vacant land gain. . . . . . . . . . . . Netting. . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . Ted
Collectibles
Unrecaptured
Depreciation
Other
28%
25%
15%
$4,000
$ 980
$0
(1,000)
$(1,000)
1,000
$0
$0
$0
$4,000
(1,000)
$3,000
(1,400)
7,000
$6,580
$6,580 and Carol Smith would report a $3,000 N25CG and a $6,580 N15CG.
A Form 4797, Schedule D and Schedule D Tax Worksheet containing the information
from Examples 19 and 20 are included in Exhibit 17.4 that follows. Note that neither the
Form 4797 nor Schedule D Parts I or II require the taxpayer to distinguish the 25% gains
from the 28% or 15% gains. These distinctions come into view on Schedule D, Part III
Summary where Line 18 refers to the 28% Rate Gain Worksheet and Line 19 requires identification of the amount of unrecaptured § 1250 Gain Worksheet (i.e., the 25% gain). The
actual tax is computed on the Schedule D Tax Worksheet that can be found in the instructions for Form 1040 for Schedule D. On the Schedule D Tax Worksheet, the rates are more
apparent (line 24 - 15%, line 30 - 25%, and line 33 - 28%). The tax for the taxpayers in
Examples 19 and 20 is computed on the Schedule D Tax Worksheet, assuming the taxpayers
have taxable income of $126,830 as computed below. Note that the taxable income includes
the capital gains and recapture.
Wages . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $136,250
Section 1245 recapture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500
Capital gains
N15CG. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $6,580
N25CG. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000
9,580
Adjusted gross income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $146,330
Standard deduction for 2012 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (11,900)
Exemptions for 2012 (2 3 $3,800). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ( 7,600)
Taxable income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $126,830
Tax per Schedule D Tax Worksheet. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 23,110
17-28
Chapter 17
Property Transactions: Dispositions of Trade or Business Property
EXHIBIT 17.4
Form
Completed Form 4797
4797
OMB No. 1545-0184
Sales of Business Property
(Also Involuntary Conversions and Recapture Amounts
Under Sections 179 and 280F(b)(2))
G Attach to your tax return.
G Information about Form 4797 and its separate instructions iswww.irs.gov/form4797.
at
Department of the Treasury
Internal Revenue Service
2012
Attachment
Sequence No.
Name(s) shown on return
Identifying number
Ted & Carol Smith
123-45-6789
1
Enter the gross proceeds from sales or exchanges reported to you for 2012 on Form(s) 1099-B or 1099-S
(or substitute statement) that you are including on line 2, 10, or 20 (see instructions)
Part I
2
of property
3
4
5
6
7
1
Sales or Exchanges of Property Used in a Trade or Business and Involuntary Conversions From Other
Than Casualty or Theft ' Most Property Held More Than 1 Year (see instructions)
(a) Description
Auto
27
(b) Date acquired
(month, day, year)
(c) Date sold
(month, day, year)
03/01/09
10/02/12
(d) Gross
sales price
(e) Depreciation
1,800.
allowed or
allowable since
acquisition
(f) Cost or other
basis, plus
improvements and
expense of sale
2,080.
4,000.
Gain, if any, from Form 4684, line 39
Section 1231 gain from installment sales from Form 6252, line 26 or 37
Section 1231 gain or (loss) from like-kind exchanges from Form 8824
Gain, if any, from line 32, from other than casualty or theft
Combine lines 2 through 6. Enter the gain or (loss) here and on the appropriate line as follows:
3
4
5
6
7
(g) Gain or (loss)
Subtract (f) from the
sum of (d) and (e)
-120.
5,100.
4,980.
Partnerships (except electing large partnerships) and S corporations. Report the gain or (loss) following the
instructions for Form 1065, Schedule K, line 10, or Form 1120S, Schedule K, line 9. Skip lines 8, 9, 11, and
12 below.
Individuals, partners, S corporation shareholders, and all others. If line 7 is zero or a loss, enter the amount from
line 7 on line 11 below and skip lines 8 and 9. If line 7 is a gain and you did not have any prior year section 1231
losses, or they were recaptured in an earlier year, enter the gain from line 7 as a long-term capital gain on the
Schedule D filed with your return and skip lines 8, 9, 11, and 12 below.
8
9
Nonrecaptured net section 1231 losses from prior years (see instructions)
8
Subtract line 8 from line 7. If zero or less, enter -0-. If line 9 is zero, enter the gain from line 7 on line 12 below. If
line 9 is more than zero, enter the amount from line 8 on line 12 below and enter the gain from line 9 as a
long-term capital gain on the Schedule D filed with your return (see instructions)
9
Part II
Ordinary Gains and Losses (see instructions)
10
Ordinary gains and losses not included on lines 11 through 16 (include property held 1 year or less):
11
12
13
14
15
Loss, if any, from line 7
Gain, if any, from line 7 or amount from line 8, if applicable
Gain, if any, from line 31
Net gain or (loss) from Form 4684, lines 31 and 38a
Ordinary gain from installment sales from Form 6252, line 25 or 36
Ordinary gain or (loss) from like-kind exchanges from Form 8824
Combine lines 10 through 16
18 For all except individual returns, enter the amount from line 17 on the appropriate line of your return and skip lines
a and b below. For individual returns, complete lines a and b below:
a If the loss on line 11 includes a loss from Form 4684, line 35, column (b)(ii), enter that part of the loss here. Enter
the part of the loss from income-producing property on Schedule A (Form 1040), line 28, and the part of the loss
from property used as an employee on Schedule A (Form 1040), line 23. Identify as from ʼForm 4797, line 18a.ʼ
See instructions
16
17
b Redetermine the gain or (loss) on line 17 excluding the loss, if any, on line 18a. Enter here and on Form 1040,
line 14
BAA For Paperwork Reduction Act Notice, see separate instructions.
11
12
13
14
15
16
17
500.
500.
18 a
18 b
500.
Form 4797 (2012)
17-29
Depreciation Recapture
EXHIBIT 17.4
Completed Form 4797— Continued
Ted & Carol Smith
Gain From Disposition of Property Under Sections 1245, 1250, 1252, 1254, and 1255
Form 4797 (2012)
Part III
B
C
Page 2
(see instructions)
(b) Date acquired
(mo, day, yr)
19 (a) Description of section 1245, 1250, 1252, 1254, or 1255 property:
A
123-45-6789
Land and building
Photocopier
07/14/02
06/12/03
(c) Date sold
(mo, day, yr)
11/21/12
08/31/12
D
These columns relate to the properties on lines
19A through 19D
G
20
Gross sales price (Note: See line 1
before completing.)
20
21 Cost or other basis plus expense of sale
21
22 Depreciation (or depletion) allowed or allowable
22
23 Adjusted basis. Subtract line 22 from line 21 23
24 Total gain. Subtract line 23 from line 20
24
25 If section 1245 property:
a Depreciation allowed or allowable from line 2225 a
b Enter the smaller of line 24 or 25a
25 b
26 If section 1250 property: If straight
line depreciation was used, enter -0on line 26g, except for a corporation
subject to section 291.
a Additional depreciation after 1975 (see instrs) 26 a
b Applicable percentage multiplied by
smaller
the
26 b
of line 24 or line 26a (see instructions)
c Subtract line 26a from line 24. If residential rental
propertyor line 24 is not more than line 26a, skip
lines 26d and 26e
26 c
d Additional depreciation after 1969 & before 1976
26 d
e Enter the smaller of line 26c or 26d
26 e
f Section 291 amount (corporations only)
26f
g Add lines 26b, 26e, and 26f
26 g
Property A
Property B
14,000.
13,000.
4,000.
9,000.
5,000.
Property C
Property D
2,600.
2,500.
500.
2,000.
600.
500.
500.
0.
0.
5,000.
0.
27
If section 1252 property:Skip this section if you
did not dispose of farmland or if this form is
being completed for a partnership (otheranthan
electing large partnership).
a Soil, water, and land clearing expenses
27 a
b Line 27a multiplied by applicable
percentage (see instructions)
27 b
c Enter the smaller of line 24 or 27b
27 c
28 If section 1254 property:
a Intangible drilling and development costs,
expenditures for development of mines and other
natural deposits, mining exploration costs, and
28a
depletion (see instructions)
b Enter the smaller of line 24 or 28a
28 b
29 If section 1255 property:
a Applicable percentage of payments
excluded from income under
section 126 (see instructions)
29 a
b Enter thesmaller of line 24 or 29a (see instrs) 29 b
Summary of Part III Gains. Complete property columns A through D through line 29b before going to line 30.
30 Total gains for all properties. Add property columns A through D, line 24
31 Add property columns A through D, lines 25b, 26g, 27c, 28b, and 29b. Enter here and on line 13
32 Subtract line 31 from line 30. Enter the portion from casualty or theft on Form 4684, line 33. Enter the
portion from other than casualty or theft on Form 4797, line 6
Part IV
30
31
5,600.
500.
32
5,100.
Recapture Amounts Under Sections 179 and 280F(b)(2) When Business Use Drops to 50% or Less
(see instructions)
(a) Section 179
33 Section 179 expense deduction or depreciation allowable in prior years
34 Recomputed depreciation (see instructions)
35 Recapture amount. Subtract line 34 from line 33. See the instructions for where to report
BAA
FDIZ1002 09/13/12
33
34
35
(b) Section
280F(b)(2)
Form 4797 (2012)
17-30
Chapter 17
Property Transactions: Dispositions of Trade or Business Property
EXHIBIT 17.5
Completed Schedule D
SCHEDULE D
Department of the Treasury
Internal Revenue Service
OMB No. 1545-0074
Capital Gains and Losses
(Form 1040)
(99)
2012
G Attach to Form 1040 or Form 1040NR.
G Information about Schedule D and its separate instructions iswww.irs.gov/form1040.
at
G Use Form 8949 to list your transactions for lines 1, 2, 3, 8, 9, and 10.
Attachment
Sequence No.
12
Name(s) shown on return
Your social security number
Ted & Carol Smith
123-45-6789
Part I
Short-Term Capital Gains and Losses ' Assets Held One Year or Less
Complete Form 8949 before completing line 1, 2,
or 3. This form may be easier to complete if you
round off cents to whole dollars.
1 Short-term totals from all Forms 8949 with
box A checked in Part I
(d) Proceeds (sales
price) from Form(s)
8949, Part I, line 2,
column (d)
3,200.
(e) Cost or other basis
from Form(s) 8949,
Part I, line 2,
column (e)
(g) Adjustments to
gain or loss from
Form(s) 8949, Part I,
line 2, column (g)
4,200.
(h) Gain or (loss)
Subtract column (e) from
column (d) and combine
the result with column (g)
-1,000.
2 Short-term totals from all Forms 8949 with
box B checked in Part I
3 Short-term totals from all Forms 8949 with
box C checked in Part I
4 Short-term gain from Form 6252 and short-term gain or (loss) from Forms 4684, 6781, and 8824
4
5 Net short-term gain or (loss) from partnerships, S corporations, estates, and trusts from Schedule(s) K-1
5
6 Short-term capital loss carryover. Enter the amount, if any, from line 8 of your Capital Loss Carryover
Worksheet in the instructions
6
7 Net short-term capital gain or (loss). Combine lines 1 through 6 in column (h). If you have any long-term
capital gain or losses, go to Part II below. Otherwise, go to Part III on page 2
7
Part II
-1,000.
Long-Term Capital Gains and Losses ' Assets Held More Than One Year
Complete Form 8949 before completing line 8, 9,
or 10. This form may be easier to complete if you
round off cents to whole dollars.
(d) Proceeds (sales
price) from Form(s)
8949, Part II, line 4,
column (d)
(e) Cost or other basis
from Form(s) 8949,
Part II, line 4,
column (e)
(g) Adjustments to
gain or loss from
Form(s) 8949, Part II,
line 4, column (g)
8
Long-term totals from all Forms 8949 with
box A checked in Part II
9
Long-term totals from all Forms 8949 with
box B checked in Part II
10
Long-term totals from all Forms 8949 with
box C checked in Part II
11
Gain from Form 4797, Part I; long-term gain from Forms 2439 and 6252; and long-term gain or (loss) from
Forms 4684, 6781, and 8824
11
12
Net long-term gain or (loss) from partnerships, S corporations, estates, and trusts from Schedule(s) K-1
12
13
Capital gain distributions. See instrs
13
14
Long-term capital loss carryover. Enter the amount, if any, from line 13 of your Capital Loss Carryover
Worksheet in the instructions
14
15,200.
9,600.
15 Net long-term capital gain or (loss). Combine lines 8 through 14 in column (h). Then go to Part III on
page 2
BAA For Paperwork Reduction Act Notice, see your tax return instructions.
(h) Gain or (loss)
Subtract column (e) from
column (d) and combine
the result with column (g)
5,600.
4,980.
15
10,580.
Schedule D (Form 1040) 2012
Depreciation Recapture
EXHIBIT 17.5
Schedule D (Form 1040) 2012
Part III
Completed Schedule D—Continued
Ted & Carol Smith
?
?
123-45-6789
Page 2
Summary
16 Combine lines 7 and 15 and enter the result
?
17-31
16
9,580.
If line 16 is a gain, enter the amount from line 16 on Form 1040, line 13, or Form 1040NR, line 14. Then
go to line 17 below.
If line 16 is a loss, skip lines 17 through 20 below. Then go to line 21. Also be sure to complete line 22.
If line 16 is zero, skip lines 17 through 21 below and enter -0- on Form 1040, line 13, or Form 1040NR,
line 14. Then to go line 22.
17 Are lines 15 and 16 both gains?
X Yes. Go to line 18.
No. Skip lines 18 through 21, and go to line 22.
18 Enter the amount, if any, from line 7 of the 28% Rate Gain Worksheet in the instructions
G 18
19 Enter the amount, if any, from line 18 of the Unrecaptured Section 1250 Gain Worksheet in
the instructions
G 19
3,000.
20 Are lines 18 and 19 both zero or blank?
Yes. Complete the Qualified Dividends and Capital Gain Tax Worksheet in the instructions
for Form 1040, line 44 (or in the instructions for Form 1040NR, line 42). Do not complete lines
21 and 22 below.
X No. Complete the Schedule D Tax Worksheet in the instructions. Do not complete lines
21 and 22 below.
21 If line 16 is a loss, enter here and on Form 1040, line 13, or Form 1040NR, line 14, the smaller of:
?
?
The loss on line 16 or
($3,000), or if married filing separately, ($1,500)
21
Note. When figuring which amount is smaller, treat both amounts as positive numbers.
22 Do you have qualified dividends on Form 1040, line 9b, or Form 1040NR, line 10b?
Yes. Complete the Qualified Dividends and Capital Gain Tax Worksheet in the instructions
for Form 1040, line 44 (or in the instructions for Form 1040NR, line 42).
No. Complete the rest of Form 1040 or Form 1040NR.
Schedule D (Form 1040) 2012
17-32
Form
Chapter 17
8949
Department of the Treasury
Internal Revenue Service
Property Transactions: Dispositions of Trade or Business Property
OMB No. 1545-0074
Sales and Other Dispositions of Capital Assets
2012
G Information about Form 8949 and its separate instructions is at www.irs.gov/form8949.
G File with your Schedule D to list your transactions for lines 1, 2, 3, 8, 9, and 10 of Schedule D.
Attachment
Sequence No.
12A
Name(s) shown on return
SSN or taxpayer identification no.
Ted & Carol Smith
123-45-6789
Most brokers issue their own substitute statement instead of using Form 1099-B. They also may provide basis information (usually your cost) to you on the statement even if it is not
reported to the IRS. Before you check Box A, B, or C below, determine whether you received any statement(s) and, if so, the transactions for which basis was reported to the IRS.
Brokers are required to report basis to the IRS for most stock you bought in 2011 or later.
Part I
Short-Term. Transactions involving capital assets you held one year or less are short term. For longterm transactions, see page 2.
You must check Box A, B, or C below. Check only one box. If more than one box applies for your short-term transactions, complete a separate
Form 8949, page 1, for each applicable box. If you have more short-term transactions than will fit on this page for one or more of the boxes,
complete as many forms with the same box checked as you need.
X (A) Short-term transactions reported on Form(s) 1099-B showing basis was reported to the IRS
(B) Short-term transactions reported on Form(s) 1099-B showing basis was not reported to the IRS
(C) Short-term transactions not reported to you on Form 1099-B
1
(a)
Description of property
(Example: 100 shares XYZ Co)
100.0000 sh. XY Corp.
(b)
Date acquired
(Mo, day, yr)
08/01/12
(c)
Date sold or
disposed
(Mo, day, yr)
12/01/12
(d)
Proceeds
(sales price)
(see instructions)
3,200.
(e)
Cost or other basis.
See the Note below
and see Column (e)
in the separate
instructions
4,200.
Adjustment, if any, to gain or loss.
If you enter an amount in column (g),
enter a code in column (f).
See the separate instructions.
(f)
Code(s) from
instructions
(g)
Amount of
adjustment
(h)
Gain or (loss).
Subtract column
(e) from column
(d) and combine
the result with
column (g)
-1,000.
2 Totals. Add the amounts in columns (d), (e), (g), and (h)
(subtract negative amounts). Enter each total here and
include on your Schedule D, line 1 (if Box A above is
checked), line 2 (if Box B above is checked), or line 3 (if
Box C above is checked)
3,200.
4,200.
-1,000.
G
Note. If you checked Box A above but the basis reported to the IRS was incorrect, enter in column (e) the basis as reported to the IRS, and enter
an adjustment in column (g) to correct the basis. See Column (g) in the separate instructions for how to figure the amount of the adjustment.
BAA For Paperwork Reduction Act Notice, see your tax return instructions.
FDIA9212 12/31/12
Form 8949 (2012)
17-33
Depreciation Recapture
Form 8949 (2012)
Attachment Sequence No.
12A Page 2
Name(s) shown on return. (Name and SSN or taxpayer identification no. not required if shown on other side.)
SSN or taxpayer identification no.
Ted & Carol Smith
123-45-6789
Most brokers issue their own substitute statement instead of using Form 1099-B. They also may provide basis information (usually your cost) to you on the statement even if it is not
reported to the IRS. Before you check Box A, B, or C below, determine whether you received any statement(s) and, if so, the transactions for which basis was reported to the IRS. Brokers
are required to report basis to the IRS for most stock you bought in 2011 or later.
Part II
Long-Term. Transactions involving capital assets you held more than one year are long term. For
short-term transactions, see page 1.
You must check Box A, B, or C below. Check only one box. If more than one box applies for your long-term transactions, complete a separate
Form 8949, page 2, for each applicable box. If you have more long-term transactions than will fit on this page for one or more of the boxes,
complete as many forms with the same box checked as you need.
X
(A) Long-term transactions reported on Form(s) 1099-B showing basis was reported to the IRS
(B) Long-term transactions reported on Form(s) 1099-B showing basis was not reported to the IRS
(C) Long-term transactions not reported to you on Form 1099-B
3
(a)
Description of property
(Example: 100 shares XYZ Co)
(b)
Date acquired
(Mo, day, yr)
(c)
Date sold or
disposed
(Mo, day, yr)
(d)
Proceeds
(sales price)
(see instructions)
(e)
Cost or other basis.
See the Note below
and see Column (e)
in the separate
instructions
Adjustment, if any, to gain or loss.
If you enter an amount in column (g),
enter a code in column (f).
See the separate instructions.
(f)
Code(s) from
instructions
(g)
Amount of
adjustment
(h)
Gain or (loss).
Subtract column
(e) from column
(d) and combine
the result with
column (g)
100.0000 sh. GB Corp.
12/01/09
12/01/12
3,200.
4,600.
-1,400.
Vacant Land
12/01/07
12/01/12
12,000.
5,000.
7,000.
4 Totals. Add the amounts in columns (d), (e), (g), and (h)
(subtract negative amounts). Enter each total here and
include on your Schedule D, line 8 (if Box A above is
checked), line 9 (if Box B above is checked), or line 10 (if
Box C above is checked)
15,200.
9,600.
5,600.
Note. If you checked Box A above but the basis reported to the IRS was incorrect, enter in column (e) the basis as reported to the IRS, and
enter an adjustment in column (g) to correct the basis. See Column (g) in the separate instructions for how to figure the amount
of the adjustment.
FDIA9212 12/31/12
Form 8949 (2012)
17-34
Chapter 17
Property Transactions: Dispositions of Trade or Business Property
EXHIBIT 17.5
Completed Schedule D—Continued
Form 1040
Line 44
Schedule D Tax Worksheet
2012
G Keep for your records
Name(s) Shown on Return
Social Security Number
Ted & Carol Smith
1 a
b
c
2 a
b
c
3
4 a
b
c
5
6
7 a
b
c
8
9 a
b
c
10
11 a
b
c
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
Enter your taxable income from Form 1040, line 43
Enter the amount from your (and your spouseʼs) Form 2555, line 45
Add lines 1a and 1b
Enter your qualified dividends
from Form 1040, line 9b
2a
Enter any capital gain excess
attributable to qualified dividends
b
Subtract line 2b from line 2a
2c
Amount from Form 4952, line 4g 3
Amount from Form 4952, line 4e 4 a
Amount from the dotted line
next to Form 4952, line 4e
b
Line 4b, if applicable, 4a, if not
c
Subtract line 4c from line 3.
5
0.
Subtract line 5 from line 2c. If zero or less, enter -06
0.
Enter line 15 of Schedule D
7 a 10,580.
Enter line 16 of Schedule D
b
9,580.
Enter the smaller of line 7a or line 7b
7c
9,580.
Enter the smaller of line 3 or line 4c
8
Subtract line 8 from line 7.
9a
9,580.
Enter any capital gain excess attributable to
capital gains
b
Subtract line 9b from line 9a
9c
9,580.
Add lines 6 and 9c
Enter the amount from Schedule D, line 18
11 a
0.
Enter the amount from Schedule D, line 19
b
3,000.
Add lines 11a and 11b
11 c
3,000.
Enter the smaller of line 9c or line 11c
Subtract line 12 from line 10
Subtract line 13 from line 1c. If zero or less, enter -0Enter:
? $35,350 if single or married filing separately;
? $70,700 if married filing jointly or qualifying widow(er); or
15
70,700.
? $47,350 if head of household.
Enter the smaller of line 1c or line 15
Enter the smaller of line 14 or line 16
17
70,700.
Subtr ln 10 from ln 1c. If zero or less, enter -018 117,250.
Enter the larger of line 17 or line 18
Subtract line 17 from line 16. This amount is taxed at 0%
If lines 1c and 16 are the same, skip lines 21 through 33
and go to line 34. Otherwise, go to line 21.
Enter the smaller of line 1c or line 13
21
6,580.
Enter the amount from line 20 (if line 20 is blank, enter -0-)
22
0.
Subtract line 22 from line 21. If zero or less, enter -0Multiply line 23 by 15% (.15)
If Schedule D, line 19, is zero or blank, skip lines 25 through 30
and go to line 31. Otherwise, go to line 25.
Enter the smaller of line 9c above or Schedule D, line 19
25
3,000.
Add lines 10 and 19
26 126,830.
Enter the amount from line 1c above
27 126,830.
Subtract line 27 from line 26. If zero or less, enter -028
0.
Subtract line 28 from line 25. If zero or less, enter -0Multiply line 29 by 25% (.25)
If Schedule D, line 18, is zero or blank, skip lines 31 through 33
and go to line 34. Otherwise, go to line 31.
Add lines 19, 20, 23, and 29
Subtract line 31 from line 1c
Multiply line 32 by 28% (.28)
Figure the tax on the amount on line 19. If the amount on line 19 is less than $100,000,
use the Tax Table to figure this tax. If the amount on line 19 is $100,000 or more,
use the Tax Computation Worksheet
Add lines 24, 30, 33, and 34
Figure the tax on the amount on line 1c. If the amount on line 1c is less than $100,000,
use the Tax Table to figure this tax. If the amount on line 1c is $100,000 or more,
use the Tax Computation Worksheet
Tax on all taxable income (including capital gains and qualified dividends).
Enter the smaller of line 35 or line 36. Also include this amount on Form 1040, line 44
123-45-6789
1 a 126,830.
b
10
9,580.
12
3,000.
16
70,700.
19
20
117,250.
0.
23
6,580.
29
3,000.
31
32
1 c 126,830.
13
14
6,580.
120,250.
24
987.
30
750.
33
34
35
21,373.
23,110.
36
23,768.
37
23,110.
17-35
Depreciation Recapture
A dditional R ecapture —C orporations
Corporations generally compute the amount of § 1245 and § 1250 ordinary income recapture on the sales of depreciable assets in the same manner as do individuals. However,
Congress added Code § 291 to the tax law in 1982 with the intent of reducing the tax benefits of the accelerated cost recovery of depreciable § 1250 property available to corporate
taxpayers. For sales or other taxable dispositions of § 1250 property, corporations must treat
as ordinary income 20 percent of any § 1231 gain that would have been ordinary income
if § 1245 rather than § 1250 had applied to the transaction.44 The effect of this provision
is to require the taxpayer to recapture 20 percent of any straight-line depreciation that has
not been recaptured under some other provision. Technically, the amount that is treated as
ordinary income under § 291 is computed in the following manner:
Amount that would be treated as ordinary income under § 1245 . . . . . . . . . . . . . . . . . Less: Amount that would be treated as ordinary income § 1250 . . . . . . . . . . . . . . . $xx,xxx
(x,xxx)
Equals: Difference between recapture amounts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Times: Rate specified in § 291 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $xx,xxx
320%
Equals: Amount that is treated as ordinary income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . $xx,xxx
Example 21
This year K Corporation sold residential rental property for $500,000. The property
was purchased for $400,000 in 1986. Assume that K claimed ACRS depreciation
of $140,000 (i.e., do not attempt to verify this estimate). Straight-line depreciation
would have been $105,000. K’s depreciation recapture and § 1231 gain are computed
as follows:
Step 1:
Compute realized gain:
Sales price. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $500,000
Less:
Adjusted basis
Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $400,000
ACRS depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (140,000)(260,000).
(260,000)
Realized gain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $240,000
Step 2:Compute excess depreciation:
Actual depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $140,000
Straight-line depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (105,000)
Excess depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 35,000
Step 3:
Compute § 1250 depreciation recapture:
Lesser of: the realized gain of $240,000 or
excess depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 35,000
§ 1250 depreciation recapture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 35,000
Step 4:
Compute depreciation recapture if § 1245 applied:
Lesser of: the realized gain of $240,000 or
actual depreciation $140,000
Depreciation recapture if § 1245 applied . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $140,000
44
§ 291(a)(1).
LO.7
Explain the additional
recapture rule
applicable only to
corporate taxpayers.
17-36
Chapter 17
Property Transactions: Dispositions of Trade or Business Property
Step 5:
Compute § 291 ordinary income:
Depreciation recapture if § 1245 applied . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $140,000
§ 1250 depreciation recapture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (35,000)
Excess recapture potential . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $105,000
Times: § 291 rate 3 20%
§ 291 ordinary income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 21,000
Step 6:
Characterize recognized gain:
§ 1250 depreciation recapture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 35,000
Plus:
§ 291 ordinary income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,000
Ordinary income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 56,000
Realized gain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $240,000
Less:
Ordinary income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (56,000)
§ 1231 gain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $184,000
Note that without the additional recapture required under § 291, K Corporation would
have reported a § 1231 gain of $205,000 ($240,000 total gain − $35,000 § 1250 recapture). If the property had been subject to § 1245 recapture, K Corporation would have
only a $100,000 § 1231 gain ($240,000 − $140,000 § 1245 recapture). Section 291
requires that the corporation report 20% of this difference ($205,000 − $100,000 5
$105,000 3 20%), or $21,000, as additional recapture. Note that this is 20% of the
straight-line depreciation that is normally not recaptured on the disposition of nonresidential or residential real estate.
Example 22
Assume the same facts as in Example 21, except that the property is an office building rather than residential realty and straight-line depreciation was elected. An
individual taxpayer would report the entire gain of $205,000 [$500,000 − ($400,000
basis − $105,000 straight-line depreciation)] as a § 1231 gain. However, the corporate
taxpayer must recapture $21,000 (20% 3 $105,000 depreciation) as ordinary income
under § 291. The remaining $184,000 ($205,000 − $21,000) would be a § 1231 gain.
O ther R ecapture P rovisions
There are several other recapture provisions that exist. They include the recapture of farmland expenditures,45 recapture of intangible drilling costs,46 and recapture of gain from the
disposition of § 126 property (relating to government cost-sharing program payments for
conservation purposes).47 Another type of recapture is investment credit recapture.48 This is
discussed in detail in Chapter 13.
C heck Y our K nowledge
Review Question 1
True-False. This year T sold equipment for $6,000 (cost $15,000, depreciation $10,000),
recognizing a gain of $1,000 ($6,000 − $5,000). To ensure that all of the ordinary deductions
45
§ 1252.
47
§ 1255.
46
§ 1254.
48
§ 47.
Depreciation Recapture
obtained from depreciation are recaptured, T must report ordinary income of $10,000 and a
capital loss of $9,000, ultimately producing net income of $1,000.
False. This novel approach may seem consistent with Congressional intent, but it is incorrect. Under § 1245 any gain realized is treated as ordinary income to the extent of any
depreciation allowed. As a result, the entire $1,000 is ordinary income. It may be useful to think of the depreciation recapture as an adjustment to the depreciation claimed.
Depreciation of $10,000 was claimed, but the value of the equipment dropped by $9,000
($15,000 cost − $6,000 sales price). T claimed an ordinary depreciation deduction of
$10,000, and recognized ordinary income of $1,000, for a net ordinary deduction of $9,000.
Review Question 2
True-False. This year L sold a machine and recognized a small gain. Assuming L claimed
straight-line depreciation, there is no depreciation recapture.
False. The machine is § 1245 property since it is depreciable personalty. Under the full recapture rule of § 1245, all depreciation is subject to recapture regardless of the method used.
Review Question 3
Several years ago Harry purchased equipment at a cost of $10,000. Over the past three years
he claimed and deducted depreciation of $6,000. Assuming that Harry sold the equipment
for (1) $7,000, (2) $13,000, or (3) $1,000, determine the amount of gain or loss realized and
its character (i.e., ordinary income or § 1231 potential capital gain).
Amount realized. . . . . . . . . . . . . . . . . . . . . . . . . . . . Adjusted basis ($10,000 − $6,000). . . . . . . . . . . . . . Gain (loss) recognized. . . . . . . . . . . . . . . . . . . . . . . . 1
2
3
$ 7,000
−4,000
$13,000
−4,000
$ 1,000
− 4,000
$ 3,000
$ 9,000
$(3,000)
The equipment is § 1245 property since it is depreciable personalty. As a result, the full
recapture rule operates and any gain recognized is ordinary income to the extent of any depreciation deducted. In the first case, the entire $3,000 is ordinary income (the lesser of the
gain recognized, $3,000, or the recapture potential, $6,000). In the second situation, $6,000
is ordinary income (the lesser of the gain recognized, $9,000, or the recapture potential,
$6,000) and $3,000 is § 1231 gain. In the final case, § 1245 does not apply because the
property is sold at a loss. Therefore, Harry has a § 1231 loss that is potentially an ordinary
loss. Its ultimate treatment depends on the outcome of the § 1231 netting process.
Review Question 4
True-False. In 1990, Sal purchased an office building to rent out. This year she sold the
building, recognizing a large gain. The entire gain is a § 1231 gain since there is no recapture under either § 1245 or § 1250.
True. The office build is § 1250 property. The recapture rules of § 1250 apply only when the
taxpayer uses an accelerated method, in which case the excess of accelerated depreciation
over straight-line is treated as ordinary income. However, since 1987 taxpayers have been
required to use the straight-line method in computing depreciation on real estate. As a result, § 1250 is inapplicable and Sal’s gain retains its original § 1231 character. Nevertheless,
the gain will not be treated as a 15 percent gain to the extent of any unrecaptured § 1250
depreciation (i.e., all of the straight-line depreciation) but rather 25 percent gain.
Review Question 5
True-False. In 1997, Z Corporation purchased an office building to rent out. This year the
corporation sold the building, recognizing a large gain. The entire gain is a § 1231 gain
since there is no recapture under either § 1245 or § 1250.
17-37
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Chapter 17
Property Transactions: Dispositions of Trade or Business Property
False. There is no recapture under § 1245 or § 1250. However, under § 291, corporate taxpayers are required to recapture up to 20 percent of any straight-line depreciation. The 25
percent rate does not apply to corporate taxpayers.
Review Question 6
True-False. In 1986, the Rose Partnership purchased a new office building to use as its
headquarters. This year the partnership sold the building, recognizing a gain of $100,000.
The partnership claimed and deducted accelerated depreciation of $40,000. Straight-line
depreciation would have been $40,000. The partnership will report ordinary income of zero
and § 1231 gain of $100,000.
False. This would be true if the building were § 1250 property, but § 1250 does not apply. Nonresidential real estate such as this office building that was acquired from 1981
through 1986 is treated as § 1245 property and is subject to the full recapture rule if accelerated depreciation was used. In this case, the taxpayer opted for accelerated depreciation, so
$40,000 is ordinary income and the remaining $60,000 is a 15% § 1231 gain.
Review Question 7
True-False. In 1984, the Daisy Partnership purchased a new apartment complex to rent out.
This year the partnership sold the building, recognizing a gain of $100,000. The partnership
claimed and deducted straight-line depreciation of $35,000. Accelerated depreciation would
have been $40,000. The partnership will report ordinary income of $35,000 and § 1231 gain
of $65,000.
False. In contrast to question 6, the property is residential real estate and is consequently
treated as § 1250 property. The partial recapture rule of § 1250 applies only if the taxpayer
actually uses an accelerated method. In this case the taxpayer used straight-line, so the recapture rules of § 1250 are not triggered. As a result, the entire $100,000 gain is a § 1231
gain. However, the gain will be a 25 percent gain to the extent of any unrecaptured § 1250
gain (i.e., the $35,000 straight-line depreciation).
Related Business Issues
I nstallment S ales
of
T rade
or
B usiness P roperty
As discussed in Chapter 14, gains on sales of trade or business property may be deferred
using the installment sale method. However, depreciation recapture does not qualify for
installment sale treatment. Thus, ordinary income from depreciation recapture must be reported in the year of sale—regardless of whether the seller received any payment in that
year.49 Consequently, only the § 1231 gain from such sales will qualify for installment gain
deferral.
Example 23
During the year, K sold a rental house for $90,000. According to the terms of the sale,
K received $30,000 down and the balance in two equal installments of $30,000 over the
next two years. K had purchased the house in 1986 for $60,000 and deducted $20,000
of accelerated depreciation. Had she used the straight-line method, the straight-line
49
§ 453(i). See Chapter 14 for a detailed discussion of
installment reporting.
Related Business Issues
depreciation would have been $15,000. K realizes a gain of $50,000 and has $5,000
of § 1250 recapture, computed as follows:
Amount realized . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $90,000
Adjusted basis ($60,000 − $20,000) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . −40,000
Gain realized. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $50,000
Accelerated depreciation on residential real estate acquired before 1987. . . . . . . . . . . . $20,000
Hypothetical straight-line depreciation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . −15,000
Excess depreciation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,000
K must report all of the depreciation recapture, $5,000, as ordinary income in the year
of the sale. In addition, she must report $15,000 of the remaining gain of $45,000 as a
§ 1231 gain under the installment sale rules for the year of sale, computed as follows:
Remaining gain, $45,000
3 $30,000 Payment received 5 $15,000 Gain recognized
Contract price, $90,000
Note that in computing the gross profit ratio, only the remaining gain is used in the
numerator and not the entire $50,000 gain realized, as would normally be the case.
I ntangible B usiness A ssets
Historically, many purchased intangible assets were not subject to amortization for tax purposes. This was because the life of the assets was indefinite and the amortization deduction
was indeterminable. However, § 197 currently allows the amortization (over 15 years) of
most purchased intangibles acquired after August 11, 1993. No amortization is allowed, of
course, for intangibles developed by the taxpayer.
For years, conventional thinking was that goodwill and similar intangibles were capital
assets. A taxpayer who purchased or developed goodwill and similar intangibles generally
recognized capital gain (or loss) to the extent the proceeds of the sale of a business were
allocated to them.
All this became much more complex with the passage of § 197. Section 197(e) stipulates
that upon the sale or disposition of § 197 assets, they are to be treated as depreciable property.
Private Letter Ruling [PLR] 200243002 brought clarity to this change. Under this ruling, intangible assets that are not subject to amortization are still treated as capital assets.
This applies to assets placed in service on or before August 11, 1993, and any self developed
goodwill and other intangibles (with no basis). However, intangibles purchased after August
11, 1993 (i.e. amortizable “§ 197 intangibles”) are to be treated as depreciable assets and
upon sale they are subject to § 1245 and § 1231 treatment.
Under § 1245, any gain recognized will be ordinary income to the extent of amortization allowed. Any remaining gain or loss will be subject to the netting process under § 1231
and whatever treatment is required after the netting process.
D ispositions of B usiness A ssets
and the S elf -E mployment T ax
Gains and losses on the disposition of business assets do not increase or decrease self-employment income. So, even though gains are ordinary income for income tax purposes to the
extent of depreciation recapture under § 1245 and § 1250, these amounts are not included
in self-employment income.
17-39
17-40
Chapter 17
Property Transactions: Dispositions of Trade or Business Property
Tax Planning Considerations
T iming
LO.8
Identify tax planning
opportunities related
to sales or other
dispositions of trade
or business property.
of
S ales
and
O ther D ispositions
Timing the sale of trade or business properties is very important and, from a tax perspective,
can be critical. In the simplest case, if a taxpayer has a tax loss or is in a lower tax bracket,
any contemplated sales at a gain should be considered to take advantage of the favorable tax
result under § 1231. If tax rates are particularly high in the current year, loss transactions
should be considered. Any net § 1231 loss is treated as an ordinary deduction for A.G.I. and
avoids the $3,000 deduction limit imposed on net capital losses.
In addition, a net § 1231 gain qualifies as a long-term capital gain. For high-income
taxpayers with no capital asset transactions or with a net capital gain in the current year, the
net § 1231 gain qualifies for the maximum capital gains tax rate of 15 percent. The benefit
can be even greater for a taxpayer with substantial capital losses for the year. Because the
losses in excess of $3,000 would otherwise be suspended, any net § 1231 gain that would be
offset by these losses can be currently recognized at no additional tax cost.
If a taxpayer has recognized or could recognize a § 1231 gain for the year and benefit from § 1231 treatment, additional sales of § 1231 property at a loss should be avoided.
Because such losses must be netted against the gains, the favorable treatment of the gains
is lost.
The look-back rule must be considered whenever a taxpayer is contemplating the timing of sales of § 1231 gain and loss assets. If no § 1231 losses have been recognized in the
past five years, the gain assets should be sold in the current year to receive the favorable
treatment of net § 1231 gains. The loss assets can then be sold in the next year and be treated
as ordinary losses. This plan will not work, however, if the loss assets are sold first.
Finally, the timing of casualty and theft gains and losses should be considered. Obviously,
a taxpayer cannot control the timing of such losses—not legally, anyway. However, the
§ 1033 gain deferral rules discussed in Chapter 15 may offer some tax planning opportunity.
Because this deferral provision is generally elective, the taxpayer should consider existing
§ 1231 gains or losses before making a decision to defer gain. For example, a taxpayer with
substantial capital losses may decide not to defer a capital gain or § 1231 gain under § 1033
even though the involuntarily converted asset is to be replaced. Immediate recognition of
the gain will not have any negative tax consequences because it can be offset by the existing
capital losses. The replacement property will have a higher (cost) basis for future depreciation. This plan is much more important to corporate taxpayers because excess capital losses
can be carried forward only five years.
S electing D epreciation M ethods
The accelerated cost recovery system provides taxpayers with several choices of depreciation methods and conventions. For example, a taxpayer with depreciable personalty may
elect to use the straight-line method and either the class life or a longer alternative life. For
real estate, an alternative 40-year life may be used.
Effect of Recapture
Generally, a taxpayer should adopt the most rapid method of depreciation available because this results in a deferral of income taxes. Unless tax rates are expected to change
significantly in the near future, the tax benefits produced by large depreciation deductions
currently allow the taxpayer the use of the money that would otherwise have been used to
pay income taxes. In addition, the availability of the like-kind exchange and involuntary
conversion provisions eliminates the risk of depreciation recapture when the taxpayer plans
to continue in business. It is also important to remember that, for noncorporate taxpayers,
there is no depreciation recapture possibility for real estate placed in service after 1986.
Because only the straight-line depreciation method can be used, there will be no excess
depreciation. However, the unrecaptured § 1250 depreciation is taxed at 25 percent.
Section 179
Tax Planning Considerations
As discussed in Chapter 9, any § 179 expense amount is treated as depreciation allowed.
As a result, the comments above may also apply in deciding whether to claim the option
to expense the cost of qualifying property. If more than one qualifying asset is placed in
service during the year and their total cost exceeds the annual limit (or reduced limit), the
taxpayer must select the assets to be expensed. Obviously, only the assets not expected to be
sold should be considered for this option. Given the time value of money, however, it seems
unlikely that any taxpayer should forgo the § 179 expense option—unless the additional
record keeping is considered to outweigh the current tax benefit.
I nstallment S ales
Installment sales provide an excellent tax deferral possibility. Caution must be exercised,
however, if trade or business property is to be sold under a deferred-payment arrangement.
Because any depreciation recapture must be reported as income in the year of sale regardless
of the amount of money received, taxpayers should require a cash down payment sufficient
to pay any income taxes resulting from the depreciation recapture.
S ales
of
B usinesses
The sale of a business typically involves some recognition of intangible assets, whether it be
goodwill, or some similar asset, or other assets such as customer lists. The buyer is generally entitled to amortize the intangibles over 15 years. The seller may have ordinary income,
capital gain, and/or § 1231 gain.
The IRS generally is required to recognize agreements between the buyer and the seller
as to the value of the various assets in the sale of a business so long as they are reasonable. Thus in negotiating the value of the underlying assets, the buyer should consider the
possible deductions related to the purchased assets. For depreciable assets and purchased
intangibles, the deductions come in the form of depreciation and amortization. With respect
to these assets, the buyer should also evaluate the effects of the depreciation recapture of the
assets if they are to be sold in a short period of time.
D ispositions of B usiness A ssets
and the S elf -E mployment T ax
Gains on the disposition of business assets do not increase self-employment income.
Similarly, losses do not reduce self-employment income. Generally speaking, foregoing
allowable depreciation is not really optional since the basis of the depreciable assets must
be reduced by depreciation allowed or allowable. So a taxpayer who does not feel like he or
she needs the deduction, and realizes that the resulting gain if the asset is sold at a gain will
be depreciation recapture, should claim it anyway!
Example 24
D purchased a machine for $4,000 in the current year. The machine qualifies for expensing under § 197. D is uncertain as to whether she should claim the entire $4,000
since she expects to sell the machine for $3,200 the next tax year. Her dilemma involves the fact that the $4,000 is an ordinary deduction and the $3,200 is an ordinary
gain. Why not just depreciate the machine? The reason is that by claiming the entire
amount, she defers the tax on $3,200 for a year—assuming no change in her marginal
tax rate.
Taxpayers paying self-employment tax should normally depreciate assets as rapidly as
possible since the depreciation allowed will reduce the self-employment tax, but the future
gain on the disposition of the asset is not includible in self-employment income.
17-41
17-42
Chapter 17
Property Transactions: Dispositions of Trade or Business Property
Example 25
D, in the prior example, can deduct the full $4,000, reducing her income tax and her
self-employment tax. However, when she sells the machine the next year, the gain is
subject only to income tax (as ordinary income).
Problem Materials
DISCUSSION QUESTIONS
17-1 Section 1231 Assets. What are § 1231 assets? What is the required holding period? Does the § 1231 category of assets include § 1245 and § 1250 assets as well?
Elaborate.
17-2 Excluded Assets. What type of property is excluded from § 1231 treatment?
17-3 Section 1231 Netting Process. Briefly describe the § 1231 netting process. Are personal use assets included in this process?
17-4 Net § 1231 Gains. What is the appropriate tax treatment of net § 1231 gains? Are
they offset by short-term capital losses? Can they be offset by capital loss carryovers
from prior years?
17-5 Net § 1231 Losses. What is the appropriate tax treatment of net § 1231 losses? Are
they subject to any annual limitation? Can they be used to create or increase a net
operating loss for the year?
17-6 Certain Casualty or Theft Gains and Losses. Which casualty or theft gains and
losses are included in the § 1231 netting process? What is the proper treatment of
a net casualty or theft gain? What is the proper treatment of a net casualty or theft
loss?
17-7 Section 1231 Look-Back Rule. Describe how the § 1231 look-back rule operates.
Why do you think Congress enacted such a rule?
17-8 Section 1245 Property. What category of trade or business property is subject to
§ 1245? What depreciable real property has been included in this category?
17-9 Full Depreciation Recapture—§ 1245. What is meant by § 1245 recapture potential?
Why is this rule sometimes called the full recapture rule? What is the lower limit of
§ 1245 recapture?
17-10 Section 1245 Recapture Potential. During the current year Z sold a vacuum used in
his pool-cleaning business. The vacuum had cost $3,600 three years ago, and he had
expensed the entire amount under § 179.
a. How much is the § 1245 recapture potential with respect to this vacuum?
b. If the vacuum was sold for $900, what is the character of the gain?
17-11 Asset Classification. When will the sale or other disposition of depreciable equipment be subject to both § 1231 and § 1245? What is the appropriate treatment of any
loss from the sale of such equipment?
17-12 Section 1245 Property. F gave property with § 1245 recapture potential to his daughter, D. Will F be required to recapture any of the depreciation previously claimed?
How must D characterize any gain she might recognize on a subsequent disposition
of the property?
17-13 Section 1245 Recapture Potential. What happens to the § 1245 recapture potential
when property is disposed of in a like-kind exchange?
Problem Materials
17-14 Section 179 Expense Treatment. Explain the proper tax treatment of any gain recognized on the disposition of an asset that the taxpayer had earlier elected to expense
under § 179. Does this mean that any amounts ever deducted under § 179 will always
be subject to recapture? Explain.
17-15 Section 1250 Property. Is land included in the definition of § 1250 property? Is any
real property depreciated under the straight-line method included in this definition?
17-16 Section 1250 Property. Is nonresidential real estate acquired after 1980 always
§ 1250 property? Explain.
17-17 Section 1250 Property. Why will depreciable real property placed in service after
1986 never be subject to § 1250 recapture? How is the un-recaptured depreciation
treated?
17-18 Section 1250 Recapture Potential. Why is § 1250 sometimes called the partial recapture rule? Will the § 1250 recapture potential ever simply disappear? Explain.
17-19 Section 1250 Recapture Potential. This year Y sold a duplex that she had rented
out for several years. The house had cost $40,000 20 years earlier and depreciation
expense of $27,000 has been claimed. Straight-line depreciation would have been
$24,500.
a. How much is the § 1250 recapture potential with respect to the duplex?
b. If the duplex was sold for $75,000, what is the character of Y’s gain and how is
it taxed?
17-20 Additional Recapture—§ 291. Briefly describe the additional depreciation recapture
rule of § 291.
a. Which taxpayers are subject to this rule?
b. Compare this to the special rate for un-recaptured depreciation on § 1250 property for individual taxpayers.
17-21 Section 291 Recapture. Can a corporation that has always elected to use the straightline depreciation method for all real property ever be subject to additional recapture
under § 291? Explain.
17-22 Reporting § 1231 Transactions. What tax form does a taxpayer use to report the
results of § 1231 transactions? How is any depreciation recapture reported on this
form?
17-23 Planning § 1231 Transactions. Under what circumstances should a taxpayer with an
involuntary conversion gain from business property consider not electing to defer
the gain under § 1033?
17-24 Planning § 1231 Transactions. A taxpayer plans to trade in depreciable property in
order to acquire new property but is quite disappointed to find that his old equipment
is worth less than its unrecovered cost basis. He is currently in the top marginal tax
bracket and has no capital gains or losses or other § 1231 transactions for the year.
What tax advice would you offer this taxpayer concerning the planned exchange?
17-25 Installment Sales and Depreciation Recapture. Briefly describe how recapture is
reported when either § 1245 property or § 1250 property is disposed of in an installment sale. What tax planning should a taxpayer undertake concerning such sales?
PROBLEMS
17-26 Characterizing Assets. Indicate whether the following gains and losses are § 1231
gains or losses or capital gains and losses or neither. Make your determination prior
to the § 1231 netting process.
a. Printing press used in A’s business; held for three years and sold at a loss.
b. Goodwill sold as part of the sale of B’s business
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Property Transactions: Dispositions of Trade or Business Property
c. Vacant lot used five years as a parking lot in C’s business; sold at a gain
d. House, 80 percent of which is D’s home and 20 percent of which is used as a
place of business; held 15 years and sold at a gain
e. Camera used in E’s business; held for 10 months and sold at a gain
f. Land used by F for 10 years as a farm and sold at a loss
g. Personal residence sold at a loss
17-27 Section 1231. During the year H sold the following assets, both of which had been
held for several years:
Asset
Vacant land held for investment
Equipment used in his business
Gain (Loss)
$52,000
(12,000)
Determine how much capital gain or loss and the amount of ordinary income or loss
that H will report for the year. At what rate will the gain, if any, be taxed?
17-28 Section 1231 Netting. G operates the Corner Bar and Grill as a sole proprietorship.
During the year he sold the following assets, all of which had been held for several
years:
Asset
IBM stock
Land and building used in the business
Equipment used in the business
Gain (Loss)
$(12,000)
34,000
(3,000)
The building had been acquired in 1993. Straight-line depreciation claimed and deducted with respect to the building was $8,000. Straight-line depreciation on the
equipment was $4,000. Determine how much capital gain or loss as well as the
amount of ordinary income or loss that G will report for the year and explain how
they will be taxed.
17-29 Involuntary Conversions and § 1231. Assume the same facts as in Problem 17-28. In
addition, G’s records revealed the following information:
• A portion of the grill’s parking lot was condemned by the city when it decided to
expand the adjacent street. G pocketed the cash and recognized a gain of $5,000.
• A pool table was destroyed as part of a barroom brawl. G realized a casualty loss
of $2,000.
Determine how much capital gain or loss as well as the amount of ordinary income
or loss that G will report for the year. At what rate will the recognized gain, if any,
be taxed?
17-30 Section 1231 Hodgepodge. For 30 years Rae has operated The General Store, a hardware store in Columbus. Rae runs the business as a sole proprietorship. During the
year, she recognized the following gains and losses from assets held several years:
1. Uninsured warehouse burned down: $10,000 loss
2. Equipment stolen $190,000 gain (ignore depreciation)
3. Parking lot sold: $120,000 gain
4. IBM stock sold capital loss of $70,000
5. Condemnation of land: $1,000 gain
Determine how much capital gain or loss as well as the amount of ordinary income
or loss that Rae will report for the year. At what rate will the gain, if any, be taxed?
Problem Materials
17-31 Section 1231 Lookback. J has recognized the following § 1231 gains and losses in
the current year (2013) and since the inception of his business:
Year
Net § 1231 Gain (Loss)
2013
2012
2011
2010
2009
2007
$50,000
12,000
(35,000)
0
65,000
(13,000)
How will J treat the $50,000 gain for the current year?
17-32 Section 1231—Timber. A owns timber land that she purchased in 1991. During the
current calendar tax year, the timber was cut and A elected § 631 treatment for the
gain. Her cost assignable to the timber was $25,000 and its fair market value on
January 1 of this year was $40,000. The actual sales price of the cut timber when it
was sold was $55,000.
a. How much is A’s gain or loss recognized and what is its character?
b. Can A deduct the costs of cutting the timber?
17-33 Section 1231—Unharvested Crops. This year L sold her farmland, which she had
owned for 20 years. L had made minor improvements to the farm and had used
straightline depreciation to depreciate them. No personal property was sold with
the farm. The sales price was $80,000 and L’s adjusted basis was $36,000. The unharvested crops on the land represented $8,000 of the sales price, and L had spent
$3,200 in producing the crop to the point of sale.
a. How does L report the gain or loss from the sale of the farm?
b. If L has no other sales of trade or business property or of capital assets, how
much of the gain is included in her taxable income?
17-34 Section 1245 Recapture. During the current year, D sold a drill press he had used in
his wood shop business for three years. D had purchased the press for $820 and had
deducted depreciation of $476. Straight-line depreciation would have been $410.
Determine the amount and character of gain or loss to D under each of the following
circumstances below:
a. The press is sold for $500.
b. The press is sold for $100.
c. The press is sold for $900.
17-35 Section 1245 Recapture. This year N sold three different pieces of equipment used
in her business:
Description
Processing machine
Work table
Automatic stapler
Holding
Period
Sales
Price
Cost
Depreciation
Allowed
3 years
4 years
2 years
$1,200
1,600
500
$1,400
1,300
900
$600
500
300
What are the amount and character of N’s gain or loss from these transactions?
17-36 Section 1245 Recapture. Fill in the missing information for each of the three independent sales of § 1245 assets identified below. Enter a dollar amount or n/a (for not
applicable) in each blank space.
Assets
Sales price. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cost. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Depreciation allowed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Depreciation recapture. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . § 1231 gain or (loss). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A
B
$105
100
30
$ 90
125
(10)
C
$
100
30
20
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17-37 Basis Reductions. Dr. T purchased a treadmill for use in his cardiology practice for
$13,000 on August 14, 2011. T claimed § 179 expense of $10,000 and depreciation
of $429 in 2010. The depreciation for 2012 and 2013 is $735 and $524, respectively.
T sold the treadmill on January 13, 2013 for $3,500,
a. What are the amount and character of T’s gain on the sale?
b. What would be your answer if the unit had been sold for $13,500?
17-38 Section 1250 Recapture. Fill in the missing information for each of the three independent sales of § 1250 assets identified below. Enter a dollar amount or n/a (for not
applicable) in each blank space.
Assets
Sales price. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cost. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Depreciation allowed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Straight-line depreciation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . Depreciation recapture. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . § 1231 gain or (loss). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . X
Y
Z
$100
135
55
$
100
$200
100
30
0
20
10
30
120
17-39 Real Property Acquired after 1986. V sold an office building in the current year
that she had purchased for $60,000 two years earlier. Depreciation of $4,127 was
claimed before the building was sold for $75,000. Determine V’s gain, its character
and the rate at which it will be taxed?
17-40 Depreciation Recapture. K purchased a warehouse on January 18, 1986 for $50,000
($10,000 allocable to the land and $40,000 allocable to the building). The property
was 19-year realty and was depreciated using the 175 percent declining balance
method and mid-month convention. The unit was sold on January 15 of the current
year for $120,000 ($30,000 allocable to the land and $90,000 allocable to the building). At the time the property was sold, the building was fully depreciated (i.e., K
deducted depreciation of $40,000 while holding the property).
a. Determine K’s gain, its character and the rate at which it will be taxed.
b. If K had used the straight-line method and a 19-year life under ACRS, the depreciation deductions would have been the same, $40,000. Determine K’s gain,
its character and the rate at which it will be taxed.
c. What would be your answer to (b) if K were a corporation?
17-41 Depreciation Recapture. Happy Acres operates a small organic farm. In the current
year, it sold some of its land including a barn for $500,000. The company purchased
the property seven years earlier for $300,000. The barn is used for multiple purposes (storage of hay, tractors, equipment, animals). For MACRS, multi-purpose
agricultural buildings are considered 20-year property and are depreciated using the
150% declining balance method (§ 168(b)(2)(A)). Assume accelerated depreciation
deducted was $125,000 and straight-line depreciation would have been $105,000.
For the following questions, ignore the land.
a. Compute the amount of gain realized and its character.
b. What amount of the gain, if any, is taxed at 25 percent?
c. What would your answer to (a) be if the company is a corporation?
17-42 Depreciation Recapture. JWP Development, an LLC, built a hotel in downtown
Chicago in 1980 at a cost of $700,000. It depreciated the building using an accelerated method over a useful life of 40 years. This year it sold the building for
$1,000,000. At the time of the sale, the company had deducted accelerated depreciation of $400,000. Straight-line depreciation on the building would have been
$150,000. (Do not try to verify these amounts.)
a. What is the amount of the company’s gain and what is its character?
b. What amount of the gain, if any, will be taxed at a 25 percent rate?
c. If the company had used the straight-line method, what would be the amount
and character of the gain? At what rate would the gain be treated?
d. What would be your answer to (a) if JWP were a corporation?
Problem Materials
17-43 Installment Sales and Recapture. Assume the same facts as in Problem 17-42 except that Z sold the property under an installment contract with $100,000 down
and $100,000 in each of the next nine years along with reasonable interest. How
much gain would Z report in the year of sale and the following year and what is its
character?
17-44 Unrecaptured § 1250 Gain. B purchased a small warehouse for $45,000 in 2009.
This year he sold the property for $62,000. He had deducted straight-line depreciation of $6,500 on the property prior to the sale. What is the amount of gain, if any,
and how will it be taxed?
17-45 Twenty-five Percent Gains. V had the following gains and losses for the current year:
§ 1250 recapture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,000
Net § 1231 gains . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000
Net short-term capital loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . (3,000)
V’s § 1231 gain was from a building that was held 15 years. The total depreciation
allowed was $5,000. How much are V’s 15 percent gains and 25 percent gains,
respectively?
17-46 Section 1231 Gain and Look-Back Rule. R sold land and a building used in farming
for many years at a gain of $30,000 during 2013. No other sales or dispositions of
§ 1231 assets were made during the year. The § 1250 depreciation recapture for the
building was zero and the unrecaptured depreciation was $1,000.
a. How is R’s gain to be reported if he had a net § 1231 gain of $10,000 in 2010, a
net § 1231 loss of $12,000 in 2011, and no § 1231 transactions in 2012?
b. How would your answer to (a) differ if the sale of the property had resulted in a
loss of $7,500?
17-47 Section 1231 and Depreciation Recapture. Fill in the missing information for each
of the separate sales of § 1231 assets indicated below. Enter a dollar amount or n/a
(for not applicable) in each blank space.
Land
Sales price. . . . . . . . . . . . . . . . . . . . . . . . . . . Cost. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Depreciation allowed . . . . . . . . . . . . . . . . . . Straight-line depreciation. . . . . . . . . . . . . . . Depreciation recapture. . . . . . . . . . . . . . . . . § 1231 gain or (loss). . . . . . . . . . . . . . . . . . . $100
140
0
0
Building
Machine
$
100
30
20
30
Machine
$90
125
$
100
30
(10)
5
17-48 Depreciation Recapture and the § 1231 Netting Process. T had three § 1231 transactions during the current year. All of the assets were held for several years.
a. Theft of electric cart used on business premises. The cart was worth $600, originally cost $800, and had an adjusted basis of $425.
b. Sale of equipment used in manufacturing. The equipment sold for $5,500, originally cost $8,000, and had an adjusted basis of $4,250.
c. Sale of land and a small building used for storage. The property was sold
for $60,000, originally cost $56,000, and had an adjusted basis of $42,500.
Straightline depreciation was claimed on the building.
Determine the amount of ordinary income or loss and capital gain or loss
that T must report from these transactions for the current year.
17-49 Section 1231 Transactions. K has the following business assets that she is interested
in selling in either 2013 or 2014.
Fair Market
Value
Basis
Manufacturing equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . $220,000 $400,000
Factory building. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 350,000 220,000
Land used for factory. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 450,000 120,000
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Straight-line depreciation of $60,000 was claimed on the factory. K has never sold
any other § 1231 assets.
a. What are the tax results if K sells the land and building in 2013 and the equipment in 2014?
b. What are the tax results if K sells the equipment in 2013 and the land and building in 2014?
c. What are the tax results if K sells all the assets in 2013?
17-50 Comprehensive Problem for Capital Asset and Trade or Business Property
Transactions. T owned a number of apartment units and sold several properties related to that trade or business during the current year as follows:
Description
Apartment unit, including land
(straight-line depreciation 5 $2,400)
Lawn tractor
Spray painter
Holding
Period
Sales
Price
Cost
Depreciation
Allowed
Method
3 years
$65,000
$24,000
$3,000
DB
5 years
2 years
1,000
500
3,000
1,400
2,600
600
SL
SL
During a severe winter storm, T also lost a depreciable motor scooter used in his
business. The scooter, which was owned by T for two years and used exclusively in
the business, had cost $2,600 and had an adjusted basis of $1,750.
In addition, T sold several capital assets during the current year as follows:
Description
100 shares LM Corp
75 shares PL, Inc
Silver ingots
Holding Period
Sales Price
Adjusted Basis
16 months
8 months
6 years
$2,000
1,600
2,600
$1,000
6,000
6,000
Assuming T has never deducted § 1231 losses before, calculate the following
amounts based on the above information:
a. The amount of § 1245 recapture and § 1250 recapture, if any.
b. The net § 1231 gain or loss.
c. The capital gain or loss and the rate at which it is taxed.
d. The net short-term capital gain or loss.
e. The overall impact of the above transactions on T’s adjusted gross income.
17-51 Netting Gains and Losses. G had the following gains and losses for the current calendar year:
DFG Corporation stock held 3 years. . . . . . . . . . . . . . . . . . . . . $4,000
Gold held 6 years. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (5,000)
Sale of business building:
§ 1250 recapture. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500
§ 1231 gain. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000
Depreciation of $7,500 had been claimed on the building. What is the character of
these gains in calculating the capital gains tax?
17-52 Capital Gains Tax. C, an unmarried head of household, has the following gains and
losses for the current taxable year:
GHJ, Inc. stock held 16 months . . . . . . . . . . . . . . . . . . . . . . . . ($3,000)
Land held for investment 15 years . . . . . . . . . . . . . . . . . . . . . . 4,000
Sale of business real estate held 15 years:
§ 1250 recapture. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,800
Net § 1231 gain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,250
Problem Materials
Depreciation claimed on the real estate was $7,800. C’s taxable income (properly
calculated and including the information above) is $121,900. How much is C’s income tax for the current calendar year?
17-53 Comprehensive Problem with Sales of Business Use Assets. O and P are married.
They have no dependents and elect to file jointly for the current year. They recently
decided to retire, sell their home, and try renting for a while. Their income and related transactions for the year follow:
Ordinary income from business . . . . . . . . . . . . . . . . . . . . . . . . $ 45,200
Interest income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,100
Sale of personal residence of 20 years:
Sales price. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $760,000
Selling costs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43,000
Adjusted basis. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 195,000
Sale of business:
§ 1245 recapture. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000
§ 1250 recapture. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26,000
§ 1231 gain. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90,000
Gain on sale of stock held 5 years. . . . . . . . . . . . . . . . . . . . . . . 16,000
Itemized deductions (after 2 percent cutback) . . . . . . . . . . . . . 23,400
O and P had claimed depreciation on the § 1245 property and the § 1250 property in the amount of $25,000 and $56,000, respectively. Calculate O and P’s adjusted gross income, taxable income, and gross income tax for the current year.
17-54 Sections 1231 and 1245 Property. The terms § 1231 property and § 1245 property
are often used interchangeably. However, there are times when a specific asset can
be classified as (1) both § 1231 and § 1245 property; (2) only § 1231 property; or
(3) only § 1245 property. Based on the values assigned to the letters below, indicate
the appropriate classification for each of the following mathematical expressions.
LetX 5 asset’s original cost
Y 5 depreciation claimed
Z 5 asset’s adjusted basis
T 5 amount realized on sale
a.
If T Z, asset is §_______ property.
b. If T > X, asset is §_______property.
c. If X > T < Z, asset is §_______property.
d. If Y > T > Z, asset is §_______property.
17-55 Section 1231 and § 1250 Property. It is possible that (1) both § 1231 and § 1250
apply to the sale of depreciable real property, (2) only § 1250 applies, or (3) only
§ 1231 applies. Based on the values assigned to the letters below, indicate which
Code sections apply for each of the following mathematical expressions.
Let X 5 asset’s original cost
Y 5 depreciation claimed
Z 5 asset’s adjusted basis
T 5 amount realized on sale
S 5 amount of straight-line depreciation
17-56
a. If Y > S and T Z, §_______ applies.
b. If Y > S and T > X, §__________ applies.
c. If Y 5 S, §_________ applies.
d. If Y > S and (T – Z) (Y – S), § applies.
Sale of Property Converted from Personal Use—Comprehensive Problem. L owned
and used a house as her personal residence since she purchased it in 2008 for $110,000.
On February 11, 2011, when it was worth $85,000, L moved out and converted the
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property into a rental property. She rented the house until December 15, 2013, when
it was sold for $104,500.
a. Determine L’s depreciation deductions for the rental property from the time it
was converted in 2011 until it was sold in 2013. Ignore land value.
b. What are the amount and character of L’s gain or loss to be recognized from the
sale?
17-57 Sale of Property Converted to Personal Use—Comprehensive Problem. Z purchased
a computer system with peripherals for $14,500 on August 12, 2010. The system
was used exclusively in his business. In October 2013, when the computer was worth
$8,200, Z closed the business and began using the unit for personal purposes.
a. Determine Z’s depreciation deductions for the computer system from the time it
was purchased until it was converted to personal use, assuming that he elected
the maximum § 179 expensing option for other assets placed into service in
2010.
b. Assume the computer system was sold for $5,400 on May 15, 2013 rather than
being converted to personal use. What are the amount and character of Z’s loss?
TAX RESEARCH PROBLEMS
17-58 Capital Assets versus § 1231 Assets. R inherited a residence that had been used exclusively by her grandmother as a principal residence for 30 years. Upon receiving
the property, R immediately offered the property for rent and rented to several tenants. After several months, R encountered an interesting potential business venture
that would require a substantial capital investment. After an agonizing decision, she
proceeded to sell her inherited rental unit. The unit was sold at a loss and R deducted
the loss under § 1231. Since she had no § 1231 gains, the loss was deducted as an
ordinary deduction. Is the treatment R chose the appropriate treatment for the loss?
Does the character of the property to her grandmother carry over to R, resulting in
disallowance of the loss or capital loss treatment?
Research aids:
Campbell v. Comm., 5 T.C. 272 (1945).
Crawford v. Comm., 16 T.C. 78 (1951), acq. 1951-2 C.B. 2.
17-59 Business Use of Personal Residence. J purchased a home in March 1992 for
$120,000. Twenty percent of its cost was attributable to the land. From the date of
purchase until March 2008, 20 percent of the house was used as a home-office, the
costs of which were properly deducted annually (including depreciation). The home
was used exclusively as J’s residence from April 2008 until the house was sold for
$325,000 on November 15, 2013.
a. J used the straight-line method and the normal useful life of 32.5 years (applicable at the time, it would be 39 years for property placed in service currently).
What amount of depreciation did he claim over the 15-year period that the property was used as a home-office?
b. Is there any depreciation recapture to be reported if gain is reported on the sale?
c. Is there depreciation recapture to be reported if all or part of the gain is excluded?