The recent reduction in capital gains tax rates underscores the importance of taxpayers planning their transactions to avoid recharacterization of Code Sec. 1231 capital gain to ordinary income when disposing of certain depreciable property. Section 1231 property is property used in a trade or business that is real property or depreciable property held for more than one year.
Net Sec. 1231 gains are taxed as long-term capital gains, while net Sec. 1231 losses are taxed as ordinary losses. Thus, ordinary income can be sheltered by Sec. 1231 losses. However, TRA 1984 reduced the advantage of Sec. 1231 by providing that any net Sec. 1231 gain is recharacterized as ordinary gain to the extent of any nonrecaptured net Sec. 1231 losses for the previous five years.
In accomplishing their purpose, the recapture provisions also operate to reduce Sec. 1231 gains. Once Sec. 1231 realized gains have been determined for a given year, it is then necessary to determine whether any gain must be recaptured under Sections 1245 and 1250. This recaptured gain is treated as ordinary income. After adjusting downward realized Sec. 1231 gains with gain recaptured as ordinary income, gains and losses of Sec. 1231 property are netted. Sections 1245 and 1250 thus apply before netting occurs under Sec. 1231.
Code Sec. 1245 greatly reduces the allure of Sec. 1231. All gain from the disposition of Sec. 1245 property is treated as ordinary income. However, gain recaptured as ordinary income can never, of course, exceed realized gain. Accordingly, Sec. 1245 has no operation where assets are sold or exchanged at a loss. The most disadvantageous aspect of Sec. 1245 is that it applies to the total amount of depreciation taken, regardless of which method of cost recovery was used.
Section 1245 property includes depreciable personal property such as equipment, automobiles, and other tangible real property. Section 1245 property also includes nonresidential real estate placed in service after 1980 and before 1987 under ACRS rules unless the straight-line depreciation was elected.
Code Sec. 1250, another recapture provision, also operates to convert what would have been Sec. 1231 gain into ordinary income. However, Sec. 1250 applies only with respect to depreciable real property other than Sec. 1245 property. The section computes an amount referred to as “additional depreciation,” and converts that amount to ordinary income. Additional depreciation is the amount by which ACRS depreciation exceeds straight-line depreciation.
Code Sec. 291 contains additional depreciation recapture rules applicable solely to corporations which dispose of depreciable real estate. This recapture is in addition to any recapture first calculated under Sec. 1250. In order to calculate Sec. 291 recapture, it is first necessary to compute the difference between the amount of recapture under Sec. 1250, and the amount that would (hypothetically) be recaptured under Sec. 1245. The amount of additional recapture under Sec. 291 is 20% of that difference.
Code Sec. 1239 operates to recharacterize gain in the context of related party transactions. A person is “related” to any corporation (or partnership) in which the individual owns, actually or constructively, more than 50% of the value of the outstanding stock (or has a capital or profits interest in excess of 50%).
Code Secs. 1245 and 1250 generally take precedence over other provisions of the tax law. A gift or devise of appreciated depreciable property will not, however, trigger recapture. Recapture will occur, however, if the donee of a lifetime gift later disposes of the property. By contrast, a bequest at death vanquishes recapture potential.
Boot received in a Code Sec. 1031 like-kind exchange results in gain recognition to the extent of boot received, or realized gain, if less. Gain recognized in such an exchange in which Sec. 1245 or 1250 property is involved is recharacterized as ordinary income to the maximum amount subject to the recapture provisions. If no gain is recognized, then the recapture taint carries over to the replacement property.