Sec. 1245 recapture rules can apply to stock.

• Author: Kashlinskaya, Alla R.

Sec. 1245 recapture rules require a taxpayer to characterize gain on the disposition of certain depreciable property as ordinary income to the extent of previously taken depreciation deductions. But those rules can also apply to a disposition of stock. This item discusses how a reduction in a debtor's stock basis through application of the Sec. 108 attribute reduction rules can result in Sec. 1245 recapture on a disposition of that stock. It also examines how the consolidated return rules in certain circumstances eliminate, in whole or in part, the potential Sec. 1245 recapture on a disposition of stock of a subsidiary member.

Sec. 108 Attribute Reduction

If a creditor discharges a debt due from a debtor, the debtor is generally required to include the amount of the cancellation of debt (COD)in gross income (Sec. 61(a) (12)). Under certain circumstances, the debtor excludes COD income from gross income under Sec. 108. For example, COD income is excluded from the debtor's gross income if the discharge occurs when the debtor is in title 11 bankruptcy proceedings. If the debtor is insolvent, COD income is excluded from gross income to the extent of the debtor's insolvency.

There is, however, a price to be paid for excluding COD income from gross income: The debtor must reduce certain tax attributes in a specified order, generally starting with net operating losses, with basis in assets being near the middle of the tax attribute reduction list (Sec. 108(b)(2)). Sec. 108(b)(5) allows the debtor an election to first reduce basis in depreciable property before returning to the general ordering rules of Sec. 108(b)(2) (a Sec. 108(b)(5) election). Any amount of COD income remaining after the debtor's tax attributes have been reduced as required disappears--i.e., the remaining amount is not included in income and does not reduce any future tax attributes (that amount is often referred to as "black hole" COD income).

Note: The American Recovery and Reinvestment Act of 2009, P.L. 111-5, allows taxpayers to elect to defer recognition of certain COD income from reacquisitions of certain debt instruments (Sec. 108(i)). The attribute reduction rules (and therefore the Sec. 1245 recapture rules discussed in this item) do not apply to COD income subject to this new deferral election.

Whether the debtor reduces basis in property by the general ordering rules of Sec. 108(b)(2) or a Sec. 108(b)(5) election, Sec. 1017 governs the tax treatment. Sec. 1017(d)...