Income and Assets · Property, real and personal

Sale or disposition of property and depreciation recapture

Two things about this topic are widely taught wrongly. The first is that gain on a rental building is subject to ”§ 1250 recapture” — for anything placed in service after 1986 it almost never is, because § 1250 recaptures only depreciation in excess of straight line and straight line is mandatory. What is actually happening is a 25 percent rate ceiling on capital gain, which is a different provision in a different part of the Code. The second is that a foreclosure is one transaction. It is often two, and which it is turns on a single checkbox on the Form 1099-A.

The rule

The computation. Gain is the excess of the amount realized over the adjusted basis provided in § 1011; loss is the excess of that adjusted basis over the amount realized (IRC § 1001(a)). The amount realized is money received plus the fair market value of property other than money received (§ 1001(b)) — and, by regulation, includes the amount of liabilities from which the transferor is discharged as a result of the disposition (Treas. Reg. § 1.1001-2(a)(1)).

Nonrecourse and recourse debt part company here. The disposition of property securing a nonrecourse liability discharges the transferor from it (Reg. § 1.1001-2(a)(4)(i)), so the whole balance enters the amount realized however little the property is worth — the regulation’s own Example 7 produces a 19,000-dollar amount realized on property worth 15,000 dollars. Where the liability is recourse, the amount realized does not include amounts that are income from the discharge of indebtedness (§ 1.1001-2(a)(2)): Example 8 splits a transfer of an asset worth 6,000 dollars against 7,500 dollars of personal liability into a 6,000-dollar amount realized and 1,500 dollars of discharge income, tested separately under § 108.

Section 1245 recapture. On a disposition of § 1245 property, the amount by which the lower of the recomputed basis or — on a sale, exchange or involuntary conversion — the amount realized, or on any other disposition the fair market value, exceeds the adjusted basis is ordinary income, recognised notwithstanding any other provision of the subtitle (IRC § 1245(a)(1)). Recomputed basis is adjusted basis plus all adjustments for depreciation or amortisation allowed or allowable, with deductions under § 179 and its neighbours treated as amortisation, and with “allowed” substituted where the taxpayer proves less was taken than was allowable (§ 1245(a)(2)(A)–(C)). Section 1245 property is depreciable property that is personal property, or certain tangible property not including a building or its structural components (§ 1245(a)(3)).

Section 1250 recapture, and why it produces nothing. On a disposition of § 1250 property, the applicable percentage of the lower of the additional depreciation attributable to periods after 1975 or the gain is ordinary income (IRC § 1250(a)(1)(A)). The applicable percentage is 100 percent for all § 1250 property outside four named housing categories (§ 1250(a)(1)(B)(v)). But additional depreciation, for property held more than one year, means the depreciation adjustments only to the extent they exceed what the straight line method would have produced (§ 1250(b)(1)) — and § 168(b)(3)(A) and (B) make the straight line method the applicable method for nonresidential real property and residential rental property. There is nothing in excess of straight line, so there is nothing to recapture.

What people mean instead is a rate ceiling. Unrecaptured section 1250 gain is taxed at 25 percent (IRC § 1(h)(1)(E)). It is defined as the long-term capital gain, not otherwise ordinary, that would have been ordinary income if § 1250(b)(1) had included all depreciation and the applicable percentage were 100 percent (§ 1(h)(6)(A)(i)). It remains capital gain throughout: it nets against capital losses and it is not recharacterised. The 25 percent is a maximum rate, so a taxpayer whose ordinary rate is lower pays the lower rate.

Both recapture sections stop at the same four doors. Neither applies to a disposition by gift (§§ 1245(b)(1), 1250(d)(1)) or, except as § 691 provides, to a transfer at death (§§ 1245(b)(2), 1250(d)(2)). On a transfer whose basis carries over under §§ 332, 351, 361, 721 or 731, recapture is capped at the gain actually recognised (§§ 1245(b)(3), 1250(d)(3)), and the same capping approach applies to a § 1031 or § 1033 disposition (§§ 1245(b)(4), 1250(d)(4)).

Then § 1231 sorts what is left. Where § 1231 gains for the year exceed § 1231 losses, both are long-term capital; where they do not, both are ordinary (IRC § 1231(a)(1), (2)). But net § 1231 gain is ordinary income to the extent of non-recaptured net § 1231 losses — the aggregate net § 1231 losses of the five most recent preceding years, less amounts already recaptured (§ 1231(c)(1), (2)).

Form 1099-A reports the event, not the tax. A person who lends money secured by property in a trade or business, and who acquires an interest in that property in satisfaction of the debt or has reason to know it has been abandoned, files a return (IRC § 6050J(a)) — not required for a loan to an individual secured by tangible personal property held neither for investment nor in a trade or business (§ 6050J(b)). Box 2 is the balance of principal outstanding, excluding accrued interest and foreclosure costs; box 4 is the fair market value; box 5 is a checkbox for whether the borrower was personally liable.

Current figures

How it works in practice

On an ordinary sale of a rental building, the sequence is short and the order matters. Compute the gain under § 1001. Ask whether any of it is § 1250 additional depreciation — on post-1986 property the answer is no. Identify the depreciation allowed or allowable and treat that much of the gain as unrecaptured section 1250 gain, carrying a 25 percent ceiling. The remainder is ordinary § 1231 gain or long-term capital gain depending on the year’s § 1231 netting and the five-year lookback. Everything reaches the return through Form 4797.

Notice what “allowed or allowable” does. Depreciation the taxpayer never claimed still feeds the recapture computation, because § 1245(a)(2)(A) reaches adjustments “allowed or allowable”. Section 1245(a)(2)(B) offers an escape only where the taxpayer can prove by adequate records that less was allowed than was allowable — a reason to fix a missed depreciation deduction, not ignore it.

On a foreclosure, read box 5 before anything else. If the borrower was personally liable, there are two computations: a disposition measured against the fair market value in box 4, and a discharge of indebtedness measured by the balance in box 2 less that value, which then goes through § 108. If the borrower was not personally liable, there is one computation, the full box 2 balance is the amount realized, and no discharge income arises at all. A loss on a personal residence is not deductible either way, but discharge income is still income.

How this has changed

Section 1250 was written for a depreciation system that no longer exists. Accelerated methods for buildings were the norm when it was enacted; the modern statute requires straight line for both nonresidential real property and residential rental property (§ 168(b)(3)(A), (B)). The section is therefore live, unrepealed and almost always productive of zero. Its four applicable-percentage categories in § 1250(a)(1)(B)(i) to (iv) all point at housing programmes of the 1960s and 1970s — one of them refers to § 167(k), long since repealed — and clause (v) sweeps everything else up at 100 percent. The result is a provision whose detailed machinery is nearly dead text while its shadow, the § 1(h)(6) definition, does the real work.

Cost segregation moved the question rather than answering it. Separating personal property and land improvements out of a building puts those components under § 1245, where recapture is real and ordinary, rather than under § 1250, where it is not. The front-end deduction is larger and the back-end character is worse, and the trade-off only becomes visible on the disposition.

Bonus depreciation and § 179 have the same effect at a smaller scale. Every dollar expensed on § 1245 property is a dollar of ordinary income waiting at the disposition. This has not changed in principle, but the amounts involved have grown by an order of magnitude, so the recapture on a routine equipment sale is now frequently the largest ordinary item on a small business return.

The recourse and nonrecourse split has not changed and remains the most misapplied rule here. Treas. Reg. § 1.1001-2 dates from 1980 and its Examples 7 and 8 still state the rule exactly. The confusion is not about the law but about the facts: whether a particular mortgage is recourse is a question of state law and of the loan documents, and the lender’s box 5 is a report of the lender’s view, not a determination.

Exam focus

Expect a rental property sale where the distractors offer § 1250 recapture as ordinary income. The answer is unrecaptured section 1250 gain at a 25 percent ceiling, and the reason is § 168(b)(3).

Expect § 1245 on equipment with a § 179 or bonus deduction in the facts, testing whether you build the recomputed basis correctly and take the lower of it and the amount realized.

Expect a Form 1099-A with box 5 either checked or not, and a question that changes answer on that fact. Read box 2 as principal only — accrued interest and foreclosure costs are excluded by the instructions.

Watch for the § 1231(c) five-year lookback, and for a disposition by gift or at death, where neither recapture section applies at all.

Check yourself

1. A taxpayer sells equipment for 30,000 dollars. Original cost 50,000 dollars, depreciation taken 38,000 dollars, adjusted basis 12,000 dollars. How much is ordinary income?

Answer: 18,000 dollars. Recomputed basis is 50,000 dollars; the lower of that and the 30,000-dollar amount realized is 30,000; the excess over the 12,000-dollar adjusted basis is 18,000, ordinary under IRC § 1245(a)(1). There is no remaining gain.

2. A commercial building placed in service in 2012 is sold at a gain of 400,000 dollars, of which depreciation allowed was 175,000 dollars. What is recaptured under § 1250?

Answer: Nothing. IRC § 168(b)(3)(A) required straight line for nonresidential real property, so there is no additional depreciation within § 1250(b)(1). The 175,000 dollars is unrecaptured section 1250 gain, capital gain with a 25 percent ceiling under § 1(h)(1)(E).

3. A Form 1099-A shows box 2 of 200,000 dollars, box 4 of 150,000 dollars, box 5 unchecked, and the property’s adjusted basis is 120,000 dollars. What is reported?

Answer: A gain of 80,000 dollars and no discharge income. Box 5 unchecked means the debt was nonrecourse, so Treas. Reg. § 1.1001-2(a)(4)(i) puts the full 200,000-dollar balance into the amount realized.

4. The same facts with box 5 checked. What changes?

Answer: The amount realized falls to the 150,000-dollar fair market value under Treas. Reg. § 1.1001-2(a)(2), giving a 30,000-dollar gain, and the 50,000-dollar difference is discharge of indebtedness income tested under IRC § 108.

5. A taxpayer has a net § 1231 gain of 60,000 dollars this year and had a net § 1231 loss of 25,000 dollars two years ago that has not been recaptured. How is the gain characterised?

Answer: 25,000 dollars is ordinary income under IRC § 1231(c)(1), because net § 1231 gain is ordinary to the extent of non-recaptured net § 1231 losses from the five most recent preceding years; the remaining 35,000 dollars is long-term capital gain.