Depreciation Recapture

If you dispose of depreciable or amortizable property at a gain, you may have to treat all or part of the gain (even if it is otherwise nontaxable) as ordinary income.

Section 1245 Property

A gain on the disposition of section 1245 property is treated as ordinary income to the extent of depreciation allowed or allowable. See Gain Treated as Ordinary Income, later.

Any recognized gain that is more than the part that is ordinary income because of depreciation is a section 1231 gain. See Treatment as ordinary or capital under Section 1231 Gains and Losses, earlier.

Defined. Section 1245 property includes any property that is or has been subject to an allowance for depreciation or amortization and is any of the following types of property.

1. Personal property (either tangible or intangible).
2. Other tangible property (except buildings and their structural components) used as any of the following.
1. An integral part of manufacturing, production, or extraction, or of furnishing transportation, communications, electricity, gas, water, or sewage disposal services.
2. A research facility in any of the activities in (a).
3. A facility in any of the activities in (a) for the bulk storage of fungible commodities.
3. That part of real property (not included in (2)) with an adjusted basis reduced by certain amortization deductions (including those for certified pollution control facilities, child-care facilities, removal of architectural barriers to persons with disabilities and the elderly, or reforestation expenses) or a section 179 deduction.
4. Single purpose agricultural (livestock) or horticultural structures.
5. Storage facilities (except buildings and their structural components) used in distributing petroleum or any primary product of petroleum.

Buildings and structural components. Section 1245 property does not include buildings and structural components. The term building includes a house, barn, warehouse, or garage. The term structural component includes walls, floors, windows, doors, central air conditioning systems, light fixtures, etc.

Do not treat a structure that is essentially machinery or equipment as a building or structural component. Also, do not treat a structure that houses property used as an integral part of an activity as a building or structural component if the structure's use is so closely related to the property's use that the structure can be expected to be replaced when the property it initially houses is replaced.

The fact that the structure is specially designed to withstand the stress and other demands of the property and cannot be used economically for other purposes indicates it is closely related to the use of the property it houses. Structures such as oil and gas storage tanks, grain storage bins, and silos are not treated as buildings, but as section 1245 property.

Storage facility. This is a facility used mainly for the bulk storage of fungible commodities. Bulk storage means storage of a commodity in a large mass before it is used. For example, if a facility is used to store sorted and boxed oranges, it is not used for bulk storage. To be fungible, a commodity must be such that one part may be used in place of another.

Gain Treated as Ordinary Income

The gain treated as ordinary income on the sale, exchange, or involuntary conversion of section 1245 property, including a sale and leaseback transaction, is the lesser of the following amounts.

1. The depreciation and amortization allowed or allowable on the property.
2. The gain realized on the disposition (the amount realized from the disposition minus the adjusted basis of the property).

For any other disposition of section 1245 property, ordinary income is the lesser of (1) above or the amount by which its fair market value is more than its adjusted basis. See chapter 3 of Publication 544.

Use Part III of Form 4797 to figure the ordinary income part of the gain.

Depreciation taken on other property or by other taxpayers. Depreciation and amortization include the amounts you claimed on the section 1245 property as well as the following depreciation and amortization amounts.

• Amounts you claimed on property you exchanged for, or converted to, your section 1245 property in a like-kind exchange or involuntary conversion.
• Amounts a previous owner of the section 1245 property claimed if your basis is determined with reference to that person's adjusted basis (for example, the donor's depreciation deductions on property you received as a gift).

Example. Jeff Free paid $120,000 for a tractor in 1999. He depreciated it using the 150% declining balance method. The tractor is 7-year property. In February 2000 he traded it for a chopper and paid an additional $30,000. To figure his depreciation deduction for 2001, Jeff continues to depreciate the tractor as he would have before the trade. Because this is the third year of depreciation, he takes a deduction of $18,036 ($120,000 ×.1503).

Jeff can also depreciate the additional $30,000 basis on the chopper. Because this is the first year of depreciation on the $30,000, he takes a depreciation deduction of $3,213 ($30,000 × .1071). The total depreciation he can deduct is $21,249 ($18,036 + $3,213). Unless Jeff disposes of the chopper before the end of the recovery period, he can continue to depreciate the $120,000 for 5 more years and the $30,000 for 7 more years.

Depreciation and amortization. Depreciation and amortization deductions that must be recaptured as ordinary income include (but are not limited to) the following items.

1. Ordinary depreciation deductions.
2. Amortization deductions for all the following costs.
1. Acquiring a lease.
2. Lessee improvements.
3. Pollution control facilities.
4. Reforestation expenses.
5. Section 197 intangibles.
6. Child care facility expenses incurred before 1982.
7. Franchises, trademarks, and trade names acquired before August 11, 1993.
3. The section 179 deduction.
4. Deductions for all the following costs.
1. Removing barriers to the disabled and the elderly.
2. Tertiary injectant expenses.
3. Depreciable clean-fuel vehicles and refueling property (minus any recaptured deduction).
5. Any basis reduction for the investment credit (minus any basis increase for a credit recapture).
6. Any basis reduction for the qualified electric vehicle credit (minus any basis increase for a credit recapture).

Example. You file your returns on a calendar year basis. In February 1999, you bought and placed in service for 100% use in your farming business a light-duty truck (5-year property) that cost $10,000. You used the half-year convention, and your MACRS deductions for the truck were $1,500 in 1999 and $2,550 in 2000. You did not take the section 179 deduction on it. You sold the truck in May 2001 for $7,000. The MACRS deduction in 2001, the year of sale, is $893 ( 1/2 of $1,785). Figure the gain treated as ordinary income as follows.

Depreciation allowed or allowable. You generally use the greater of the depreciation allowed or allowable when figuring the part of gain to report as ordinary income. If, in prior years, you have consistently taken proper deductions under one method, the amount allowed for your prior years will not be increased even though a greater amount would have been allowed under another proper method. If you did not take any deduction at all for depreciation, your adjustments to basis for depreciation allowable are figured by using the straight line method.

This treatment applies only when figuring what part of the gain is treated as ordinary income under the rules for section 1245 depreciation recapture.

Disposition of plants and animals. If you made the choice not to apply the uniform capitalization rules (see chapter 7), you must treat any plant you produce, or any animal you produced in 1987 or 1988, as section 1245 property. If you have a gain on the property's disposition, you must recapture the preproductive expenses you would have capitalized if you had not made the choice by treating the gain, up to the amount of these expenses, as ordinary income. For section 1231 transactions, show these expenses as depreciation on line 22, Part III, of Form 4797. For plant sales that are reported on Schedule F, this recapture rule does not change the reporting of income because the gain is already ordinary income. You can use the farm-price method or the unit-livestock-price method discussed in chapter 3 to figure these expenses.

Example. Janet Maple sold her apple orchard in 2001 for $80,000. Her adjusted basis at the time of sale was $60,000. She bought the orchard in 1994, but the trees did not produce a crop until 1997. Her preproductive expenses were $6,000. She chose not to apply the uniform capitalization rules. Janet must treat $6,000 of the gain as ordinary income.

Livestock costs incurred before 1989. For livestock costs incurred before 1989, the IRS provided two safe-harbor choices for applying the uniform capitalization rules. These safe-harbor choices were not available to corporations, partnerships, or tax shelters required to use an accrual method of accounting. For information on these choices, see Notice 88-24 in Cumulative Bulletin 1988-1 and Notice 88-113 modifying Notice 88-24 in Cumulative Bulletin 1988-2.

Section 1250 Property

Section 1250 property includes all real property subject to an allowance for depreciation that is not and never has been section 1245 property. It includes a leasehold of land or section 1250 property subject to an allowance for depreciation. A fee simple interest in land is not section 1250 property because it is not depreciable.

Gain on the disposition of section 1250 property is treated as ordinary income to the extent of additional depreciation allowed or allowable. To determine the additional depreciation on section 1250 property, see Additional Depreciation, later.

You will not have additional depreciation if any of the following apply.

• You figured depreciation for the property using the straight line method or any other method that does not result in more depreciation than the amount figured by the straight line method, and you have held the property longer than a year.
• You chose the alternate ACRS (straight line) method for the types of 15-, 18-, or 19-year real property covered by the section 1250 rules.
• You dispose of residential rental property or nonresidential real property placed in service after 1986 (or after July 31, 1986, if the choice to use MACRS was made). These properties are depreciated using the straight line method.

Gain Treated as Ordinary Income

To find what part of the gain from the disposition of section 1250 property is treated as ordinary income, follow these steps.

1. In a sale, exchange, or involuntary conversion of the property, figure the amount realized that is more than the adjusted basis of the property. In any other disposition of the property, figure the fair market value that is more than the adjusted basis.
2. Figure the additional depreciation for the periods after 1975.
3. Multiply the lesser of (1) or (2) by the applicable percentage, discussed later. Stop here if this is residential rental property or if (2) is equal to or more than (1). This is the gain treated as ordinary income because of additional depreciation.
4. Subtract (2) from (1).
5. Figure the additional depreciation for periods after 1969 but before 1976.
6. Add the lesser of (4) or (5) to the result in (3). This is the gain treated as ordinary income because of additional depreciation.

Use Part III, Form 4797, to figure the ordinary income part of the gain.

Additional Depreciation

If you hold section 1250 property longer than 1 year, the additional depreciation is the actual depreciation adjustments that are more than the depreciation figured using the straight line method. For a list of items treated as depreciation adjustments, see Depreciation and amortization under Section 1245 Property, earlier.

If you hold section 1250 property for 1 year or less, all the depreciation is additional depreciation.

Figure straight line depreciation for ACRS real property by using its 15-, 18-, or 19-year recovery period as the property's useful life.

The straight line method is applied without any basis reduction for the investment credit.

You will have additional depreciation if you use the regular ACRS method, the declining balance method, the sum-of-the-years-digits method, the units-of-production method, or any other method of rapid depreciation. You also have additional depreciation if you choose amortization, other than amortization on real property that qualifies as section 1245 property, discussed earlier.

Depreciation taken by other taxpayers or on other property. Additional depreciation includes all depreciation adjustments to the basis of section 1250 property whether allowed to you or another person (as for carryover basis property).

Depreciation allowed or allowable. You generally use the greater of depreciation allowed or allowable (to any person who held the property if the depreciation was used in figuring its adjusted basis in your hands) when figuring the part of the gain to be reported as ordinary income. If you can show the deduction allowed for any tax year was less than the amount allowable, the lesser figure will be the depreciation adjustment for figuring additional depreciation.

Applicable Percentage

The applicable percentage used to figure the ordinary income because of additional depreciation depends on whether the real property you disposed of is nonresidential real property, residential rental property, or low-income housing. The applicable percentages for nonresidential real property and residential rental property are explained next. The applicable percentage for low-income housing is explained in chapter 3 of Publication 544.

Nonresidential real property. For real property that is not residential rental property, the applicable percentage for periods after 1969 is 100%. For periods before 1970, the percentage is zero and no ordinary income will result from its disposition because of additional depreciation taken before 1970.

Residential rental property. For residential rental property (80% or more of the gross income is from dwelling units) other than low-income housing, the percentage for periods after 1975 is 100%. The applicable percentage for periods before 1976 is zero. No ordinary income will result from a disposition of residential rental property because of additional depreciation before 1976.

More information. For more information about depreciation recapture on section 1250 property, see chapter 3 of Publication 544.

Installment Sale

If you report the sale of property under the installment method, any depreciation recapture under section 1245 or 1250 is taxable as ordinary income in the year of sale. This applies even if no payments are received in that year. If the gain is more than the depreciation recapture income, report the rest of the gain using the rules of the installment method. For this purpose, add the recapture income to the property's adjusted basis.

If you dispose of more than one asset in a single transaction, you must separately figure the gain on each asset so that it may be properly reported. To do this, allocate the selling price and the payments you receive in the year of sale to each asset. Report any depreciation recapture income in the year of sale before using the installment method for any remaining gain.

For more information on installment sales, see chapter 12.

Other Dispositions

Chapter 3 of Publication 544 discusses the tax treatment of the following transfers of depreciable property.

• By gift.
• At death.
• In like-kind exchanges.
• In involuntary conversions.

Publication 544 also explains how to handle a single transaction involving multiple properties.

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