The ins and outs of recapture.

• Author: Everett, John O.
• Position: Part 1

EXECUTIVE SUMMARY

* Gain on the sale or disposition of depreciable business property may be recharacterized as ordinary income under various recapture provisions.

* For Sec. 1245 property, all depreciation claimed or allowable is subject to recapture, up to the total gain amount.

* Corporations are subject to Sec. 291, which recaptures up to 20% of the gain in excess of Sec. 1250 recapture; individuals are subject to a 25% capital gain rate on unrecaptured Sec. 1250 gain.

Tax advisers and their clients should know how the depreciation recapture provisions can operate to recharacterize capital gain as ordinary income. Part I of this two-part article explains the basic rules that apply to corporate and individual taxpayers.

Depreciation recapture can be minimized with proper planning. The depreciation recapture provisions and their application to both corporate and individual taxpayers are discussed and illustrated in Part I of this article, below. Part II, in the August 2005 issue, will cover exceptions to the recapture rules, gain reporting and recapture planning.

Background

The creation of Sec. 1231 initially gave businesses disposing of long-term depreciable assets the best of all possible worlds: net Sec. 1231 gains were preferentially taxed as long-term capital gains, while net Sec. 1231 losses were fully deductible as ordinary losses. By 1962, however, Congress felt taxpayers were abusing Sec. 1231 to convert ordinary income into capital gains. Businesses claimed accelerated depreciation deductions against ordinary income, rapidly lowering a property's basis and increasing the opportunity for gain on disposal. Any resulting gain, however, was not ordinary income but, rather, potential long-term capital gain under Sec. 1231(a). In response, Congress passed Secs. 1245 and 1250, to convert all or part of the capital gain to ordinary income through depreciation recapture. Subsequent legislation introduced Sec. 291 recapture for corporations, as well as the special 25% recapture rate on "unrecaptured Sec. 1250 gain" for individuals.

Basic Principles

Depreciation recapture applies to the disposal of an asset only when (1) property was held on a long-term basis (more than one year), (2) depreciation or amortization was claimed on the property and (3) the property was disposed of at a gain.

Example 1: J wishes to sell the following assets used in his business:

1. Equipment held 9 months (fair market value (FMV) $20,000; adjusted basis $17,000).

2. Land held 5 years (FMV $80,000; basis $40,000).

3. Furniture held 3 years (FMV $30,000; adjusted basis $48,000).

4. A building held 10 years (FMV $500,000; adjusted basis $325,000).

   Of the four assets, depreciation recapture would apply only to the building. The other items are not subject to depreciation recapture, because the equipment has not been held for over a year (all of its gain on disposal will be ordinary income), the land is not subject to depreciation (all of its gain will be Sec. 1231 gain) and the furniture's disposal results in a Sec. 1231 loss.

   The recapture provisions generally do not determine the realized or recognized gain or loss on an asset's disposal; rather, they determine only the tax character of any gain. Recapture provisions such as Secs. 1245 and 1250 take precedence over other Code sections and, in isolated cases, may require gain recognition despite the existence of other nonrecognition provisions. (1)

   Sec. 1245 Recapture

   Sec. 1245 classifies gains on the disposition of qualifying assets as ordinary income, equal to all depreciation claimed since 1962. However, the ordinary income cannot exceed the total gain. Thus, Sec. 1245 ordinary income is the lesser of total recognized gain or all depreciation chimed.

   The depreciation or amortization method used (e.g., accelerated or straight-line) does not affect Sec. 1245 depreciation recapture. All depreciation claimed or allowable is subject to recapture. As a result, Sec. 1245 recaptures (1) depreciation claimed under Sec. 167, (2) cost recovery under Sec. 168, (3) Sec. 197 amortization, (4) expensing under Sec. 1792 and (5) the additional 30% or 50% first-year depreciation deduction under Sec. 168(k)(1)(A) and (4)(A)(i).

   Example 2: T placed in service a $160,000 plating machine (7-year property under the modified accelerated cost recovery system (MACRS)) in September 2003. T elected to expense $100,000 of the cost under Sec. 179 and used 50% bonus depreciation for the excess. In 2005, T sells the machine for $120,000. T's adjusted basis at the time of the sale is $15,743, computed as follows:

   Original cost $160,000 Less: Sec. 179 deduction (100,000) Bonus depreciation ($60,000 x 0.50) (30,000) MACRS deduction for 2003 ($30,000 x 0.1429) (4,287) MACRS deduction for 2004 ($30,000 x 0.2449) (7,347) MACRS deduction for 2005 ($30,000 x 0.1749 x 0.5) (2,623) Adjusted basis $15,743 T's recognized gain is $104,257 ($120,000 amount realized--$15,743 adjusted basis). The entire $104,257 gain is recaptured as ordinary income under Sec. 1245, because it is less than the $144,257 total depreciation taken (which includes the Sec. 179 deduction and 50% bonus depredation).

   Any gain greater than total depreciation is Sec. 1231 gain. This will rarely occur, because it...