Chapter 17
Property Transactions: §1231 and
Recapture Provisions
Individual Income Taxes
Copyright ©2009 Cengage Learning
Individual Income Taxes
C17-1
§1231 Assets
(slide 1 of 4)
• §1231 assets defined
– Depreciable and real property used in a business or for
production of income and held greater than 1 year
– Includes timber, coal, iron, livestock, unharvested crops
– Certain purchased intangibles
Individual Income Taxes
C17-2
§1231 Assets
(slide 2 of 4)
• §1231 property does not include the following:
– Property not held for the long-term holding period
– Nonpersonal use property where casualty losses exceed
casualty gains for the taxable year
– Inventory and property held primarily for sale to
customers
– Copyrights, literary, musical, or artistic compositions
and certain U.S. government publications
– Accounts receivable and notes receivable arising in the
ordinary course of a trade or business
Individual Income Taxes
C17-3
§1231 Assets
(slide 3 of 4)
• If transactions involving §1231 assets result
in:
– Net §1231 loss = ordinary loss
– Net §1231 gain = long-term capital gain
Individual Income Taxes
C17-4
§1231 Assets
(slide 4 of 4)
• Provides the best of potential results for the
taxpayer
– Ordinary loss that is fully deductible FOR AGI
– Gains subject to the lower capital gains tax
rates
Individual Income Taxes
C17-5
Special Rules For
Certain §1231 Assets (slide 1 of 4)
• Timber-Taxpayer can elect to treat the cutting of
timber held for sale or for use in business as a sale
or exchange
• If elected, transaction qualifies under §1231
• Recognized §1231 gain or loss is determined at the
time the timber is cut
– Equal to difference between timber's FMV as of first day
of tax year and the adjusted basis for depletion
– If sold for more or less than FMV as of first day of tax
year in which it is cut,difference is ordinary income or loss
Individual Income Taxes
C17-6
Special Rules For
Certain §1231 Assets (slide 2 of 4)
• Livestock
– Cattle and horses must be held 24 months or
more and other livestock must be held 12
months or more to qualify under §1231
Individual Income Taxes
C17-7
Special Rules For
Certain §1231 Assets (slide 3 of 4)
• Casualty gains and losses from §1231 assets and
from long-term nonpersonal use capital assets are
determined and netted together
• If a net loss, items are treated separately
– §1231 casualty gains and nonpersonal use capital asset
casualty gains are treated as ordinary gains
– §1231 casualty losses are deductible FOR AGI
– Nonpersonal use capital asset casualty losses are
deductible FROM AGI subject to the 2% of AGI limitation
• If a net gain, treat as §1231 gain
Individual Income Taxes
C17-8
Special Rules For
Certain §1231 Assets (slide 4 of 4)
• The special netting process for casualties & thefts
does not include condemnation gains and losses
– A § 1231 asset disposed of by condemnation receives
§ 1231 treatment
• Personal use property condemnation gains and
losses are not subject to the § 1231 rules
– Gains are capital gains
• Personal use property is a capital asset
– Losses are nondeductible
• They arise from the disposition of personal use property
Individual Income Taxes
C17-9
General Procedure for
§ 1231 Computation (slide 1 of 3)
• Step 1: Casualty Netting
– Net all recognized long-term gains & losses from
casualties of § 1231 assets and nonpersonal use capital
assets
• If casualty gains exceed casualty losses, add the excess to the
other § 1231 gains for the taxable year
• If casualty losses exceed casualty gains, exclude all casualty
losses and gains from further § 1231 computation
– All casualty gains are ordinary income
– Section 1231 asset casualty losses are deductible for AGI
– Other casualty losses are deductible from AGI
Individual Income Taxes
C17-10
General Procedure for
§ 1231 Computation (slide 2 of 3)
• Step 2: § 1231 Netting
– After adding any net casualty gain from previous step
to the other § 1231 gains and losses, net all § 1231
gains and losses
• If gains exceed the losses, net gain is offset by the ‘‘lookback’’
nonrecaptured § 1231 losses from the 5 prior tax years
– To the extent of this offset, the net § 1231 gain is classified as
ordinary gain
– Any remaining gain is long-term capital gain
• If the losses exceed the gains, all gains are ordinary income
– Section 1231 asset losses are deductible for AGI
– Other casualty losses are deductible from AGI
Individual Income Taxes
C17-11
General Procedure for
§ 1231 Computation (slide 3 of 3)
• Step 3: § 1231 Lookback Provision
– The net § 1231 gain from the previous step is
offset by the nonrecaptured net § 1231 losses
for the five preceding taxable years
• To the extent of the nonrecaptured net § 1231 loss,
the current-year net § 1231 gain is ordinary income
– The nonrecaptured net § 1231 losses are those that have
not already been used to offset net § 1231 gains
• Only the net § 1231 gain exceeding this net § 1231
loss carryforward is given long-term capital gain
treatment
Individual Income Taxes
C17-12
Lookback Provision Example
• Taxpayer had the following net §1231 gains
and losses:
2006
$ 4,000 loss
2007
10,000 loss
2008
16,000 gain
– In 2008, taxpayer’s net §1231 gain of $16,000
will be treated as $14,000 of ordinary income
and $2,000 of long-term capital gain
Individual Income Taxes
C17-13
§1231 Netting Procedure
(slide 1 of 2)
Net Gain
§1231 asset and long-term nonpersonal use
capital asset casualty gains
minus
§1231 asset and long-term nonpersonal use
capital asset casualty losses
Net Loss
Items treated separately: Gains are
ordinary income, §1231 asset
losses are deductible for AGI,
Other losses deductible from AGI
Net Gain
(add to §1231 gains)
§1231 gains
minus
§1231 losses
Net Loss
Net Gain
Individual Income Taxes
C17-14
§1231 Netting Procedure
(slide 2 of 2)
Net Gain
Lookback Provision:
Net gain is offset against
nonrecaptured net §1231 losses
from 5 prior tax years
Gain offset by lookback
losses is ordinary gain
Individual Income Taxes
Remaining gain
is LTCG
C17-15
Depreciation Recapture
(slide 1 of 3)
• Assets subject to depreciation or cost
recovery may be subject to depreciation
recapture when disposed of at a gain
– Losses on depreciable assets receive §1231
treatment
• No recapture occurs in loss situations
Individual Income Taxes
C17-16
Depreciation Recapture
(slide 2 of 3)
• Depreciation recapture characterizes gains
that would appear to be §1231 as ordinary
gain
– The Code contains two major recapture
provisions
• §1245
• §1250
Individual Income Taxes
C17-17
Depreciation Recapture
(slide 3 of 3)
• Depreciation recapture provisions generally
override all other Code Sections
– There are exceptions to depreciation recapture
rules, for example:
• In dispositions where all gain is not recognized
– e.g., like-kind exchanges, involuntary conversions
• Where gain is not recognized at all
– e.g., gifts and inheritances
Individual Income Taxes
C17-18
§1245 Recapture
(slide 1 of 3)
• Depreciation recapture for §1245 property
– Applies to tangible and intangible personalty,
and nonresidential realty using accelerated
methods of ACRS (placed in service 1981-86)
• Recapture potential is entire amount of accumulated
depreciation for asset
• Method of depreciation does not matter
Individual Income Taxes
C17-19
§1245 Recapture
(slide 2 of 3)
• When gain on the disposition of a §1245
asset is less than the total amount of
accumulated depreciation:
– The total gain will be treated as depreciation
recapture (i.e., ordinary income)
Individual Income Taxes
C17-20
§1245 Recapture
(slide 3 of 3)
• When the gain on the disposition of a §1245
asset is greater than the total amount of
accumulated depreciation:
– Total accumulated depreciation will be
recaptured (as ordinary income), and
– The gain in excess of depreciation recapture
will be §1231 gain or capital gain
Individual Income Taxes
C17-21
Observations on § 1245
• Usually total depreciation taken will exceed the recognized gain
– Therefore, disposition of § 1245 property usually results in ordinary
income rather than § 1231 gain
– Thus, generally, no § 1231 gain will occur unless the § 1245 property is
disposed of for more than its original cost
• Recapture applies to the total amount of depreciation allowed or
allowable regardless of the depreciation method used
• Recapture applies regardless of the holding period of the property
– If held for < the long-term holding period the entire recognized gain is
ordinary income because § 1231 does not apply
• Section 1245 does not apply to losses, which receive § 1231 treatment
• Gains from the disposition of § 1245 assets may also be treated as
passive activity gains
Individual Income Taxes
C17-22
§1250 Recapture
(slide 1 of 2)
• Depreciation recapture for §1250 property
– Applies to depreciable real property
• Exception: Nonresidential realty classified as §1245 property
(i.e., placed in service after 1980 and before 1987, and
accelerated depreciation used)
– Intangible real property, such as leaseholds of § 1250
property, is also included
Individual Income Taxes
C17-23
§1250 Recapture
(slide 2 of 2)
• Section 1250 recapture rarely applies since only
the amount of additional depreciation is subject to
recapture
– To have additional depreciation, accelerated
depreciation must have been taken on the asset
• Straight-line depreciation is not recaptured (except for property
held one year or less)
– Depreciable real property placed in service after 1986
can generally only be depreciated using the straight-line
method
• Therefore, no depreciation recapture potential for such
property
– § 1250 does not apply if the real property is sold at a
loss
Individual Income Taxes
C17-24
Real Estate 25% Gain
(slide 1 of 4)
• Also called unrecaptured §1250 gain or
25% gain
– 25% gain is some or all of the §1231 gain
treated as long-term capital gain
– Used in the alternative tax computation for net
capital gain
Individual Income Taxes
C17-25
Real Estate 25% Gain
(slide 2 of 4)
• Maximum amount of 25% gain is depreciation
taken on real property sold at a recognized
gain reduced by:
– Certain §1250 and §1245 depreciation recapture
– Losses from other §1231 assets
– §1231 lookback losses
• Limited to recognized gain when total gain is less
than depreciation taken
Individual Income Taxes
C17-26
Real Estate 25% Gain
(slide 3 of 4)
• Special 25% Gain Netting Rules
– Where there is a § 1231 gain from real estate and that
gain includes both potential 25% gain and potential
0%/15% gain, any § 1231 loss from disposition of other
§ 1231 assets
• First offsets the 0%/15% portion of the § 1231 gain
• Then offsets the 25% portion of the § 1231 gain
– Also, any § 1231 lookback loss
• First recharacterizes the 25% portion of the § 1231 gain
• Then recharacterizes the 0%/15% portion of the § 1231 gain as
ordinary income
Individual Income Taxes
C17-27
Real Estate 25% Gain
(slide 4 of 4)
• Net § 1231 Gain Limitation
– The amount of unrecaptured § 1250 gain may not
exceed the net § 1231 gain that is eligible to be treated
as long-term capital gain
– The unrecaptured § 1250 gain is the lesser of
• The unrecaptured § 1250 gain, or
• The net § 1231 gain that is treated as capital gain
– Thus, if there is a net § 1231 gain, but it is all
recaptured by the 5 year § 1231 lookback loss
provision, there is no surviving § 1231 gain or
unrecaptured § 1250 gain
Individual Income Taxes
C17-28
Related Effects of Recapture
(slide 1 of 8)
• Gifts
– The carryover basis of gifts, from donor to
donee, also carries over depreciation recapture
potential associated with asset
– That is, donee steps into shoes of donor with
regard to depreciation recapture potential
Individual Income Taxes
C17-29
Related Effects of Recapture
(slide 2 of 8)
• Inheritance
– Death is only way to eliminate recapture
potential
– That is, depreciation recapture potential does
not carry over from decedent to heir
Individual Income Taxes
C17-30
Related Effects of Recapture
(slide 3 of 8)
• Charitable contributions
– Recapture potential reduces the amount of
charitable contribution deductions that are
based on FMV
Individual Income Taxes
C17-31
Related Effects of Recapture
(slide 4 of 8)
• Nontaxable transactions
– When the transferee carries over the basis of the
transferor, the recapture potential also carries over
• Included in this category are transfers of property pursuant to
the following:
–
–
–
–
Nontaxable incorporations under § 351
Certain liquidations of subsidiary companies under § 332
Nontaxable contributions to a partnership under § 721
Nontaxable reorganizations
– Gain may be recognized in these transactions if boot is
received
• If gain is recognized, it is treated as ordinary income to the
extent of the recapture potential or recognized gain, whichever
is lower
Individual Income Taxes
C17-32
Related Effects of Recapture
(slide 5 of 8)
• Like-kind exchanges and involuntary
conversions
– Property received in these transactions have a
substituted basis
• Basis of former property and its recapture potential
is substituted for basis of new property
– Any gain recognized on the transaction will
first be treated as depreciation recapture, then
as §1231 or capital gain
• Any remaining recapture potential carries over
Individual Income Taxes
C17-33
Related Effects of Recapture
(slide 6 of 8)
• Installment sales
– Recapture gain is recognized in year of sale
regardless of whether gain is otherwise
recognized under the installment method
Individual Income Taxes
C17-34
Related Effects of Recapture
(slide 7 of 8)
• Property Dividends
– A corporation generally recognizes gain on the
distribution of appreciated property to
shareholders
– Recapture applies to the extent of the lower of
the recapture potential or the excess of the
property’s FMV over its adjusted basis
Individual Income Taxes
C17-35
Related Effects of Recapture
(slide 8 of 8)
• Sales between related parties
– Sales of depreciable assets between related
parties can cause the total gain to be recognized
as ordinary income
• Applies to related party sales or exchanges of
property that is depreciable in hands of transferee
Individual Income Taxes
C17-36
If you have any comments or suggestions concerning this
PowerPoint Presentation for South-Western Federal
Taxation, please contact:
Dr. Donald R. Trippeer, CPA
trippedr@oneonta.edu
SUNY Oneonta
Individual Income Taxes
C17-37