Property Transactions: §1231 and Recapture Provisions

Property Transactions: §1231 and Recapture Provisions
Chapter 17 Property Transactions: §1231 and Recapture Provisions

The Big Picture (slide 1 of 2)
Hazel Brown owns and operates a retail arts and crafts store. She is a sole proprietor and files a Form 1040, Schedule C. In 2009, she remodeled the store and replaced the store equipment (counters, display racks, etc.) at a cost of $450,000. All of the equipment was used (she bought it from a competitor that was going out of business). The equipment is 7 year MACRS property. She took $250,000 of § 179 expense on it and depreciated the balance. 2

The Big Picture (slide 2 of 2)
As of June 30, 2012, the equipment has an adjusted basis of $74,960. $450,000 cost - $250,000 § 179 expense - $125,040 of MACRS depreciation. Now, Hazel is again planning on replacing the store equipment. She can sell all of the existing equipment for $128,000. If Hazel completes this transaction, what will be the impact on her 2012 tax return? Read the chapter and formulate your response. 3

§1231 Assets (slide 1 of 4) §1231 assets defined
Depreciable and real property used in a business or for production of income and held >1 year Includes timber, coal, iron, livestock, unharvested crops Certain purchased intangibles 4

§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

§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

§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

The Big Picture - Example 1 § 1231 Assets
Return to the facts of The Big Picture on p If Hazel sells the store equipment, she will have disposed of a § 1231 asset because it was depreciable property used in a trade or business and held for more than 12 months. Her gain will be $53,040. $128,000 selling price - $74,960 adjusted basis. Part of the gain may be treated as a long-term capital gain under § 1231. Recapture rules may apply (discussed later in this chapter). 8

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

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

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

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

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

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

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

Lookback Provision Example
Taxpayer had the following net §1231 gains and losses: 2010 $ 4,000 loss 2011 $10,000 loss 2012 $16,000 gain In 2012, 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

Section 1231 Netting Procedure

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

Depreciation recapture characterizes gains that would appear to be §1231 as ordinary gain The Code contains two major recapture provisions §1245 §1250

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

§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 ) Recapture potential is entire amount of accumulated depreciation for asset Method of depreciation does not matter

§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)

§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

The Big Picture - Example 8 §1245 Recapture (slide 1 of 3)
Return to the facts of The Big Picture on p Hazel purchased the equipment for $450,000 She has taken $375,040 of depreciation on it. $250,000 § 179 expense + $125,040 regular MACRS depreciation The equipment’s adjusted basis is $74,960. If Hazel sells the equipment for $128,000, she will have a gain of $53,040. $128,000 − $74,960 24

Return to the facts of The Big Picture on p If it were not for § 1245, the $53,040 gain would be § 1231 gain. Section 1245 prevents this potentially favorable result by treating as ordinary income (not as § 1231 gain) any gain to the extent of depreciation taken. In this example, the entire $53,040 gain would be ordinary income. 25

Return to the facts of The Big Picture on p If Hazel sold the machine for $485,000, she would have a gain of $410,040. $485,000 − $74,960 adjusted basis. The § 1245 gain would be $375,040 Equal to the depreciation taken. The § 1231 gain would be $35,000. Equal to the excess of the sales price over the $450,000 original cost. 26

Observations on § 1245 (slide 1 of 3)
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 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

§1250 Recapture (slide 1 of 3) 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

§1250 Recapture (slide 2 of 3) 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

§1250 Recapture (slide 3 of 3) The § 1250 recapture rules also apply to the following property for which accelerated depreciation was used: Additional first-year depreciation [§ 168(k)] exceeding straight-line depreciation taken on leasehold improvements, qualified restaurant property, and qualified retail improvement property. Immediate expense deduction [§ 179(f)] exceeding straight-line depreciation taken on leasehold improvements, qualified restaurant property, and qualified retail improvement property. 32

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

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

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

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

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

Inheritance Death is only way to eliminate recapture potential That is, depreciation recapture potential does not carry over from decedent to heir

Charitable contributions Recapture potential reduces the amount of charitable contribution deductions that are based on FMV

The Big Picture - Example 20 Depreciation Recapture and Charitable Transfers
Return to the facts of The Big Picture on p If instead of selling the old equipment Hazel gives it to a charity, her charitable contribution is limited to zero. The potential § 1245 recapture on the equipment is $375,040 (the depreciation taken). When that amount is subtracted from the equipment’s $128,000 fair market value, the result is zero. 40

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

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

The Big Picture - Example 21 Depreciation Recapture and Like-Kind Exchanges
Return to the facts of The Big Picture on p Rather than sell the equipment, Hazel could exchange it for equipment worth $150,000. Hazel would have to pay $22,000 and would have a § 1031 like-kind exchange. $150,000 FMV of equip. rec’d – $128,000 FMV of the equip. given up Because boot was given (the $22,000 cash) and not received, her realized gain of $53,040 is not recognized $128,000 FMV of equip. given up − $74,960 adjusted basis of the equip. given up. The $375,040 of depreciation recapture potential under § 1245 carries over to the replacement equipment. 43

Installment sales Recapture gain is recognized in year of sale regardless of whether gain is otherwise recognized under the installment method

The Big Picture - Example 22 Depreciation Recapture and Installment Sales
Return to the facts of The Big Picture on p Assume Hazel could sell the used equipment for $28,000 down and the balance in five yearly installments of $20,000 plus interest. She would have to recognize her entire $53,040 gain ($128,000 sale price - $74,960 adjusted basis) in 2012. All of the gain is § 1245 depreciation recapture gain because the $375,040 depreciation taken exceeds the $53,040 recognized gain. 45

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

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

Refocus On The Big Picture (slide 1 of 2)
Hazel maximized her depreciation deductions when she acquired the store equipment in 2009. When she sells the equipment in 2012, however, she has a gain because of the low adjusted basis resulting from the § 179 immediate expensing and the rapid seven-year MACRS depreciation. Section 1245 ‘‘recaptures’’ this gain as ordinary income. 48

Refocus On The Big Picture (slide 2 of 2)
One way Hazel could avoid recognizing the $53,040 ($128, $74,960) gain would be to do a like-kind exchange. Trade the 2009 equipment for the new equipment. She would likely have to give up the 2009 equipment plus cash to acquire the replacement equipment. Thus, there would be no ‘‘boot received’’ and, therefore, no current gain recognized. However, the depreciation recapture potential on the 2009 equipment would carry over to the replacement equipment. 49

Dr. Donald R. Trippeer, CPA
If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact: Dr. Donald R. Trippeer, CPA SUNY Oneonta

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Property Transactions: §1231 and Recapture Provisions

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