II. Sections 1245 and 1250: Depreciation Recapture

II. Sections 1245 and 1250: Depreciation Recapture

The basis of an allowance for depreciation is the notion that a taxpayer consumes a portion, but only a portion, of an asset that enables him/her/it to generate income over a period longer than one year. The Code treats that bit of “consumption” the same as any other consumption that enables a taxpayer to generate income, i.e., a deduction from ordinary income. See §§ 162, 212. Such an allowance requires an equal reduction in taxpayer’s basis in the asset. See § 1016(a)(2).

We learn shortly that the Code treats gain upon the sale of most assets subject to depreciation – and therefore not capital assets, § 1222(a)(2) – that taxpayer has held for more than one year as LTCG. This would mean that whatever gain taxpayer realizes that is attributable to basis reductions resulting from deductions for depreciation would be subject to a lower rate of tax than the income against which taxpayer claimed those deductions.¹⁹² The Code addresses this mismatch of character of income and deductions through “depreciation recapture” provisions, i.e., §§ 1245¹⁹³ and 1250.¹⁹⁴
A. Section 1245
Section 1245 provides that a taxpayer realizes ordinary income upon a disposition¹⁹⁵ of “section 1245 property” to be measured by subtracting its adjusted basis from the lesser of the property’s “recomputed basis” or the amount realized.¹⁹⁶ § 1245(a)(1).

•A property’s “recomputed basis” is its adjusted basis plus all “adjustments reflected in such adjusted basis on account of deductions (whether in respect of the same or other property) allowed or allowable to the taxpayer or to any other person for depreciation or amortization.” § 1245(a)(2)(A).

•Taxpayer may establish “by adequate records or other sufficient evidence” that the amount allowed for depreciation or amortization was less than the amount allowable. § 1245(a)(2)(B).

•Deductions allowed by provisions other than § 167 and § 168 – notably expensing provisions that reduce taxpayer’s basis in the property – are also considered to be “amortization,” § 1245(a)(2)(C), and so become a part of the property’s “recomputed basis.”

•personal property, § 1245(a)(3)(A),

•other tangible property – not including a building or structural components – that was used as an “integral part of manufacturing, production, or extraction or of furnishing transportation, communications, electrical energy, gas, water, or sewage disposal services,” § 1245(a)(3)(B)(i), that constituted a research facility in connection with these activities, § 1245(a)(3)(B)(ii), or that constituted a facility used in connection with such activities for the bulk storage of fungible commodities, § 1245(a)(3)(B)(iii),

•real property subject to depreciation and whose basis reflects the benefit of certain special or rapid depreciation provisions, § 1245(a)(3)(C),

•a “single purpose agricultural or horticultural structure,” § 1245(a)(3)(D),

•a “storage facility (not including a building or its structural components) used in connection with the distribution of petroleum” products, § 1245(a)(3)(E), or

•a “railroad grading or tunnel bore,” § 1245(a)(3)(F).

Example:

•Taxpayer is a professional violinist who plays the violin for the local symphony orchestra. She purchased a violin bow for $100,000 in May 2011. Treat a violin bow as 7-year property. In January 2013, she sold the bow for $110,000. What is the taxable gain on which taxpayer must pay tax and what is the character of that gain?

•Taxpayer will deduct a depreciation allowance under § 168. She will apply the half-year convention to both the year in which she placed the bow in service and the year of sale. § 168(d)(4).

•Go to the tables at the front of your Code. In 2011, she will deduct 14.29% of $100,000, or $14,290. In 2012, she will deduct 24.49% of $100,000, or $24,490. In 2013, she will deduct half of 17.49% of $100,000, or $8745.

•Taxpayer’s remaining basis in the violin bow is $52,475.

•Taxpayer’s “recomputed basis” is $100,000. It is less than the amount realized. Hence, taxpayer has depreciation recapture income of $47,525. This is ordinary income. The balance of taxpayer’s gain (i.e., $10,000) is § 1231 gain, which will be subject to tax as if it were long term capital gain.

•Now the amount realized is less than taxpayer’s recomputed basis.

•Hence, taxpayer’s depreciation recapture income is $37,525. This income is subject to tax as ordinary income.
Section 1245 provides specific rules governing certain dispositions.

•Section 1245 does not apply to a disposition by gift. § 1245(b)(1). Instead, the donee takes the donor’s basis for purposes of determining gain – and includes recapture income in his/her income upon disposition of the gifted property.

•Section 1245 does not apply to a transfer at death. § 1245(b)(2). Since there is a basis step-up on property acquired from a decedent, § 1014(a), depreciation recapture is not subject to tax at all upon such a disposition.

•In certain tax-free dispositions of property between a subsidiary and its parent corporation, shareholders and a corporation, and partners and a partnership – there is no recognition of depreciation recapture. § 1245(b)(3). Instead, the recipient – who takes a carryover basis – will recognize depreciation recapture income upon disposition of the property.

•In a tax-deferred like-kind exchange (§ 1031) or involuntary conversion (§ 1033), depreciation recapture is subject to tax only to the extent the acquisition of property not qualifying for tax-deferred treatment is subject to tax plus the fmv of non-section 1245 property acquired. § 1245(b)(4). Instead gain on the disposition of the replacement property attributable to depreciation allowances on both the original and the replacement properties is depreciation recapture income.

•Section 1245 does not apply to a tax-deferred distribution of partnership property to a partner. § 1245(b)(5)(A). The partner will recognize depreciation recapture income upon his/her/its disposition of the property (subject to some very technical adjustments).

•Section 1245 does not apply to a disposition to a tax-exempt organization, § 1245(b)(3), unless the organization immediately uses the property in a trade or business unrelated to its exemption, § 1245(b)(6)(A). If the tax exempt organization later ceases to use the property for a purpose related to its exemption, it is treated as having made a disposition on the date of such cessation. § 1245(b)(6)(B).

•Special amortization rules apply to reforestation expenditures. § 194. An 84-month amortization period applies. § 194(a)(1). Ten years after acquiring the “amortizable basis” for incurring reforestation expenditures, gain on the disposition of such assets is no longer considered to be depreciation recapture. § 1245(b)(7).

•If taxpayer disposes of more than one amortizable section 197 intangible in one or more related transactions, all section 197 intangibles are considered to be one section 1245 property. § 1245(b)(8)(A). However, this rule does not apply to a section 197 intangible whose fmv is less than its adjusted basis. § 1245(b)(8)(B).
Section 1245(d) provides that § 1245 applies “notwithstanding any other provision of this subtitle.” This means that except to the extent § 1245 itself excepts its own applicability, depreciation recapture will be carved out of the gain on any disposition of depreciable or amortizable property and be subject to tax as ordinary income. This important provision limits taxpayer opportunity to mismatch the character of income against which his/she/it claims deductions with the character of subsequent resulting gain.

B. Section 1250
Section 1250 treats as ordinary income, § 1250(a)(1)(A), the recapture of so-called “additional depreciation,” i.e., the excess of depreciation adjustments over straight-line adjustments on “section 1250 property” held for more than one year. § 1250(b)(1). Section 1250 property is real property to which § 1245 does not apply. Since § 168 allowances on real property are all straight-line, the applicability of § 1250 is limited.

Nevertheless, depreciation allowances on real property are recaptured for individual taxpayers to an extent through the (complicated) interplay of § 1(h)(6) (supra) and § 1231 (infra).