Depreciation lowers a client's basis, so a later sale produces more gain. The Code also decides what character that gain has. Clients who took cost segregation or bonus deductions often learn at sale time that part of the gain is ordinary income, and a good share of the rest is taxed above the regular long-term capital gain rates. Run this analysis before the client signs the contract.
Section 1245: equipment and personal property
Under section 1245(a)(1), when section 1245 property is disposed of, the amount by which the lower of the recomputed basis or the amount realized exceeds the adjusted basis is ordinary income. Recomputed basis is the adjusted basis plus all depreciation and amortization adjustments taken. In plain terms, gain up to the depreciation taken is ordinary. Gain above original cost is not recaptured. Section 1245 property is mostly personal property, and it includes the five- and seven-year components identified in a cost segregation study, and depreciation taken as bonus is recaptured the same way.
Worked example. A client buys equipment for $100,000, takes $80,000 of depreciation, and sells it for $70,000.
- Adjusted basis: $100,000 minus $80,000, or $20,000.
- Gain: $70,000 minus $20,000, or $50,000.
- Recomputed basis is $100,000; amount realized is $70,000. The lower is $70,000.
- Ordinary income: $70,000 minus $20,000, or $50,000. All of the gain is ordinary.
If the client sold at $130,000, the gain would be $110,000. The lower figure is the recomputed basis of $100,000, so ordinary income is $80,000 and the remaining $30,000 goes through section 1231.
Section 1250: buildings
Section 1250(a) treats as ordinary income the applicable percentage of "additional depreciation," which is generally depreciation taken in excess of straight-line. Real property placed in service after 1986 is depreciated straight-line, so additional depreciation is usually zero and section 1250 produces no ordinary income for these buildings.
That does not mean the gain is taxed at the lowest capital gain rate. Section 1(h) defines unrecaptured section 1250 gain, taxed at a maximum rate of 25 percent under section 1(h)(1)(E). The statute defines it as the long-term capital gain that would be ordinary income if section 1250 included all depreciation and the applicable percentage were 100 percent. For an individual, in practice that means gain attributable to straight-line depreciation taken on the building, limited to the total gain.
Worked example. A client bought a rental building for $1,000,000 (land excluded), took $250,000 of straight-line depreciation, and sells the building for $1,300,000.
- Adjusted basis: $750,000.
- Gain: $1,300,000 minus $750,000, or $550,000.
- Unrecaptured section 1250 gain: $250,000, taxed up to 25 percent.
- Remaining gain: $300,000, taxed at the 0, 15 or 20 percent long-term rates, depending on income.
Worked example: a building sold with reclassified components
A client's $1,000,000 depreciable basis was split by a cost segregation study: $200,000 to five-year property, fully expensed under bonus depreciation, and $800,000 to the building, with $100,000 of straight-line depreciation taken. The client sells for $1,300,000, allocated $150,000 to the five-year components and $1,150,000 to the building.
- Components: adjusted basis is $0. Gain is $150,000. Recomputed basis is $200,000, which is higher than the $150,000 realized, so the lower figure is $150,000. Ordinary income is $150,000.
- Building: adjusted basis is $700,000. Gain is $450,000. Unrecaptured section 1250 gain is the $100,000 of straight-line depreciation, taxed up to 25 percent. The other $350,000 is taxed at the 0, 15 or 20 percent rates.
- Total gain is $600,000: $1,300,000 minus the combined adjusted basis of $700,000. The pieces add up: $150,000 plus $100,000 plus $350,000.
The allocation of price between components and building moves gain between ordinary income and the 25 percent bucket, so it belongs in the contract and in the file.
C corporations
Section 291(a)(1) adds a rule for corporations. For section 1250 property, 20 percent of the excess of the amount that would be ordinary income if the property were section 1245 property over the amount treated as ordinary income under section 1250 is treated as ordinary income. A corporate seller of a building therefore has ordinary income even with straight-line depreciation, and the individual 25 percent computation above does not apply to it.
Installment sales
Under section 453(i), recapture income is recognized in the year of the sale even if no payment is received that year. Recapture income is the amount that would be ordinary income under section 1245 or 1250 if all payments were received in the year of disposition. Only the gain in excess of recapture income is reported under the installment method. A seller carrying back a note on a depreciated building or equipment owes tax on the recapture portion up front. The installment method is also unavailable for dealer dispositions, under section 453(b)(2).
Exchanges and planning points
- A deferred exchange under section 1031 defers recognized gain on real property, but cash boot can pull gain into the current year.
- After a cost segregation study, project the recapture on each component class before recommending the study to a client who plans to sell within a few years.
- Use the fixed asset register to compute adjusted basis by class. Disposals recorded without the tax depreciation history produce the wrong answer.
Common errors
- Treating all gain on a cost-segregated building as capital gain.
- Computing recapture on the whole sale price without splitting it among land, building and personal property.
- Adding back only the depreciation the client claimed: section 1245(a)(2) recomputed basis adds back deductions allowed or allowable.
- Reporting an installment sale entirely under the installment method when part of the gain is recapture income.
- Applying the individual 25 percent rule to a C corporation seller.
Questions
Is bonus depreciation recaptured?
Yes, for section 1245 property. Recomputed basis adds back all depreciation and amortization adjustments, so bonus depreciation is recaptured as ordinary income up to the gain.
Does a loss create recapture?
No. Section 1245(a)(1) applies when the lower of recomputed basis or amount realized exceeds adjusted basis. If the amount realized is below adjusted basis, there is no excess and no recapture.
File checklist
- Tax depreciation schedule by asset class through the sale date.
- Allocation of the sales price among land, building and personal property, matching the purchase contract and Form 8594 if a business is sold.
- Computation of ordinary income, unrecaptured section 1250 gain and remaining gain.
- If an installment note exists, the section 453(i) recapture schedule.
Sources
- Legal Information Institute, 26 U.S.C. 1245, Gain from dispositions of certain depreciable property: https://www.law.cornell.edu/uscode/text/26/1245
- Legal Information Institute, 26 U.S.C. 1250, Gain from dispositions of certain depreciable realty: https://www.law.cornell.edu/uscode/text/26/1250
- Legal Information Institute, 26 U.S.C. 1, Tax imposed (subsection (h), maximum capital gains rate): https://www.law.cornell.edu/uscode/text/26/1
- Legal Information Institute, 26 U.S.C. 453, Installment method: https://www.law.cornell.edu/uscode/text/26/453
- Legal Information Institute, 26 U.S.C. 291, Special rules relating to corporate preference items: https://www.law.cornell.edu/uscode/text/26/291
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