Hazel Brown owns an arts and crafts store. In 2012, she is planning to sell the store equipment she purchased in 2009 for $450,000 and has since depreciated. - If she sells the equipment for $128,000, she will have a $53,040 gain. This full amount will be treated as ordinary income under §1245 recapture rules rather than potential §1231 capital gain, since the gain is less than her total depreciation of $375,040. - If she sells the equipment for more than its original $450,000 cost, the portion of gain up to her $375,040 in total depreciation would be ordinary income under §12

1. Chapter 17
Property Transactions:
§1231 and Recapture
Provisions
Individual Income Taxes
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 1

2. 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

3. 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

4. §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

5. §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
5

6. §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
6

7. §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
7

8. The Big Picture - Example 1
§ 1231 Assets
• Return to the facts of The Big Picture on p. 17-1.
• 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

9. 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
9

10. Special Rules For
Certain §1231 Assets (slide 2 of 4)
• 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
10

11. Special Rules For
Certain §1231 Assets (slide 3 of 4)
• 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
11

12. Special Rules For
Certain §1231 Assets (slide 4 of 4)
• 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
12

13. 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
13

14. General Procedure for
§ 1231 Computation (slide 2 of 3)
• 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
14

15. General Procedure for
§ 1231 Computation (slide 3 of 3)
• 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
15

16. 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
16

17. Section 1231 Netting Procedure
17

18. 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
18

19. Depreciation Recapture
(slide 2 of 3)
• Depreciation recapture characterizes gains that
would appear to be §1231 as ordinary gain
– The Code contains two major recapture provisions
• §1245
• §1250
19

20. Depreciation Recapture
(slide 3 of 3)
• 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
20

21. §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 1981-86)
• Recapture potential is entire amount of accumulated
depreciation for asset
• Method of depreciation does not matter
21

22. §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)
22

23. §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
23

24. The Big Picture - Example 8
§1245 Recapture (slide 1 of 3)
• Return to the facts of The Big Picture on p. 17-1.
• 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

25. The Big Picture - Example 8
§1245 Recapture (slide 2 of 3)
• Return to the facts of The Big Picture on p. 17-1.
• 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

26. The Big Picture - Example 8
§1245 Recapture (slide 3 of 3)
• Return to the facts of The Big Picture on p. 17-1.
• 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

27. 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
27

28. Observations on § 1245
(slide 2 of 3)
• 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
28

29. Observations on § 1245
(slide 3 of 3)
• 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
29

30. §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
30

31. §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
31

32. §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

33. 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
33

34. Real Estate 25% Gain
(slide 2 of 4)
• 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
34

35. Real Estate 25% Gain
(slide 3 of 4)
• 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
35

36. Real Estate 25% Gain
(slide 4 of 4)
• 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
36

37. 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
37

38. Related Effects of Recapture
(slide 2 of 8)
• Inheritance
– Death is only way to eliminate recapture potential
– That is, depreciation recapture potential does not
carry over from decedent to heir
38

39. Related Effects of Recapture
(slide 3 of 8)
• Charitable contributions
– Recapture potential reduces the amount of
charitable contribution deductions that are based
on FMV
39

40. The Big Picture - Example 20
Depreciation Recapture and Charitable Transfers
• Return to the facts of The Big Picture on p. 17-1.
• 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

41. Related Effects of Recapture
(slide 4 of 8)
• 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
41

42. Related Effects of Recapture
(slide 5 of 8)
• 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
42

43. The Big Picture - Example 21
Depreciation Recapture and Like-Kind Exchanges
• Return to the facts of The Big Picture on p. 17-1.
• 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

44. Related Effects of Recapture
(slide 6 of 8)
• Installment sales
– Recapture gain is recognized in year of sale
regardless of whether gain is otherwise recognized
under the installment method
44

45. The Big Picture - Example 22
Depreciation Recapture and Installment Sales
• Return to the facts of The Big Picture on p. 17-1.
• 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

46. Related Effects of Recapture
(slide 7 of 8)
• 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
46

47. Related Effects of Recapture
(slide 8 of 8)
• 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
47

48. 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

49. Refocus On The Big Picture (slide 2 of 2)
• One way Hazel could avoid recognizing the $53,040
($128,000 - $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

50. If you have any comments or suggestions concerning this
PowerPoint Presentation for South-Western Federal
Taxation, please contact:
Dr. Donald R. Trippeer, CPA
trippedr@oneonta.edu
SUNY Oneonta
© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
50