Question

Identify the recapture rules that apply to section 1245 and section 1250. Discuss how these rules affect the tax computation of an individual taxpayer.

Answer 1

Section 1245

It is codified in the United States Code (USC) at Title 26 - Internal Revenue Code (IRC), Subtitle A - Income Taxes, Chapter 1 - Normal Taxes and Surtaxes, Subchapter P - Capital Gains and Losses, Part IV - Special Rules for Determining Capital Gains and Losses, Section 1245 - Gain from dispositions of certain depreciable property.

Section 1245 recaptures depreciation or amortization allowed or allowable on tangible and intangible personal property at the time a business sells such property at a gain by taxing the gain at ordinary income rates to the extent of its allowable or allowed depreciation or amortization.Section 1245 Property is any new or used tangible or intangible personal property that has been or could have been subject to depreciation or amortization. Examples of tangible personal property are machinery, vehicles, equipment, grain storage bins and silos, blast furnaces, and brick kilns. Examples of intangible personal property are patents, copyrights, and trademarks.

Section 1245 is a mechanism to recapture at ordinary income tax rates allowable or allowed depreciation or amortization taken on section 1231 property. Allowable or allowed means that the amount of depreciation or amortization recaptured is the greater of that taken or that could have been taken but was not.

SECTION 1250

The unrecaptured section 1250 gain is a type of depreciation-recapture income that is realized on the sale of depreciable real estate. Unrecaptured Section 1250 income is taxed at a 25% maximum capital-gains rate, or less in some cases. Unrecaptured Section 1250 gains are only realized when there is a net Section 1231 gain that is not subject to recapture as ordinary income.

A section 1250 gain is recaptured upon the sale of depreciated real estate, just as with any other asset; the only difference is the rate at which it is taxed. The gain is used to offset previously used depreciation allowances, which are not optional in nature. While the gains attributed to depreciation are taxed at the capital gains tax rate, any remaining gains are only subject to the long-term capital gains rate of 15%. Assets that do not qualify under Section 1250 are taxed at a different rate.

Key Takeaways

• An unrecaptured section 1250 gain is a type of depreciation-recapture income.
• Unrecaptured section 1250 gains are usually taxed at a 25% maximum capital-gains rate.
• A section 1250 gain is recaptured when there is a sale of depreciated real estate.

Since the unrecaptured section 1250 gains are considered a form of capital gains, they can be offset by capital losses. In order to do so, the capital losses must be reported through Form 8949 and Schedule D, and the value of the loss may vary depending on if it is determined to be short-term or long-term in nature. In order for a capital loss to offset a capital gain, they must both be determined to be short-term or long-term. A short-term loss cannot offset a long-term gain and vice versa.

CONCLUSION--

Sections 1245 and 1250 were enacted to close the loophole that resulted from allowing depreciation deductions on assets to offset ordinary income while taxing gain from the sale of these depreciated assets as capital gains. Sections 1245 and 1250 close the loophole by recharacterizing part or all of the gain on transfers of depreciable assets as ordinary income.

Sections 1245 and 1250 generally apply to any transfer of depreciable property (including certain property that is expensed under rules similar to depreciation rules, such as rapid amortization property and property that has been expensed under §179). Certain transfers of depreciable property, however, are excepted from depreciation recapture.

The gain treated as ordinary income by §1245 is the amount by which the lower of the property’s (1) amount realized or fair market value (depending on the type of disposition), or (2) recomputed basis (i.e., the property’s basis plus all amounts allowed for depreciation) exceeds the property’s adjusted basis. The gain treated as ordinary income by §1250 is the applicable percentage (generally 100%) of the lower of (1) the portion of depreciation that exceeds what would have been permitted under the straight-line method, or (2) the excess of the amount realized (or fair market value, depending on the type of disposition) over the property’s adjusted basis.