The ins and outs of recapture.

• Author: Everett, John O.
• Position: Part 2

Tax advisers can help clients avoid, shift or postpone depreciation recapture on property used in a trade or business. Part II of this article discusses special recapture rules and exceptions and planning strategies for minimizing recapture.

The depreciation recapture provisions are complicated and pervasive, significantly affecting the tax on many sales, exchanges and other dispositions. However, in many cases, recapture can be reduced, delayed or even eliminated. In the July 2005 issue, Part I of this two-part article explained how the recapture provisions operate and offered examples of recapture calculations. Part II, below, discusses special recapture rules and exceptions, and suggests planning techniques.

Special Recapture Rules

For installment sales, nontaxable exchanges, charitable contributions or gifts and inheritances, the Code provides special rules when applying Sec. 1245's and 1250's recapture provisions.

Installment Sales

Sec. 453(i)(1) was amended in 1984 to provide that all depreciation recapture income on an installment sale after June 6, 1984 has to be recognized in the year of sale, regardless of the payment (if any) received in that year. The recognized recapture income increases the property's adjusted basis when calculating the gross profit percentage (GPP) applied to the actual payments received.

Example 1: G sells a depreciable machine (with an $80,000 original cost and a $40,000 basis) for $100,000, payable in five $20,000 installments beginning in 2005. Normally, in an installment sale, G would compute a GPP of 60% ($60,000 gain/$100,000 total contract price), and recognize $12,000 gain ($60,000 x 0.20) in each of the five years. However, under Sec. 453(i), G reports the entire $40,000 depreciation recapture as gain in the sale year. This decreases his GPP to 20% ($20,000/ $100,000); he would report an additional $4,000 Sec. 1231 gain for 2005 and the succeeding four years.

Nontaxable Exchanges

A taxpayer can defer realized gain on certain nontaxable exchanges and involuntary conversions. However, if boot is received, or if involuntary conversion proceeds received are not reinvested in qualifying replacement property, (8) the taxpayer must recognize gain, which is subject to depreciation recapture. (9) According to Regs. Sec. 1.1245-2(c)(2), any remaining recapture potential carries over to the property received in the exchange. Examples of these transfers include contributions to corporations or partnerships under Sec. 351 or 721, like-kind exchanges under Sec. 1031, Sec. 1033 involuntary conversions, Sec. 361 tax-free corporate reorganizations and Sec. 332 liquidations of subsidiaries.

Example 2: H exchanges an old business machine with a $3,000 adjusted basis for a new machine worth $4,000, and $500. The old machine had cost $4,800 six years ago.

Under Sec. 1031, H recognizes $500 gain on the exchange (equal to the boot received). All of it must be reported as ordinary income under Sec. 1245, because a sale of the old machine at its fair market value (FMV) of $4,500 (the value received) would have generated $1,500 Sec. 1245 income, which is less than the $1,800 total depredation allowed in prior years.

Charitable Contributions

Contributions of Sec. 1245 or 1250 properties to recognized charities are contributions of "ordinary income property" when applying the Sec. 170 limits on property contributions. Under Sec. 170(e)(1)(A) and Regs. Sec. 1.170A-4(b)(1), the charitable deduction is reduced by the ordinary income that would have been recognized had the donated asset been sold. This reduction applies only for contributions of long-term appreciated assets on which depredation has been claimed.

Example 3: R, an individual, donates a residential apartment building to a recognized charity when the building has a $60,000 adjusted basis and a $72,000 FMV. R had taken depreciation...