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Depreciation Recapture — Sections 1245 and 1250 (Portfolio 563)

Tax Management Portfolio, Depreciation Recapture — Sections 1245 and 1250, No. 563-2nd, explains the purpose of §§1245 and 1250, and describes the types of property subject to depreciation recapture.

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DESCRIPTION

Tax Management Portfolio, Depreciation Recapture — Sections 1245 and 1250, No. 563-2nd, explains the purpose of §§1245 and 1250, and describes the types of property subject to depreciation recapture.

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.

This portfolio emphasizes tax planning and discusses means for reducing the impact of §§1245 and 1250, including such strategies as the careful timing of dispositions, and the use of certain accounting methods. Sections 1245 and 1250 have an impact on taxpayers that is more significant than just the rate differential between capital gains and ordinary income. For instance, characterizing gain as ordinary rather than capital could affect a taxpayer's capital loss deduction, as well as the reporting of gain from installment sales.


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AUTHORS

VICTORIA EVE KELLY
Victoria Eve Kelly graduated cum laude from Barnard College (Columbia University) in 1978 with a B.A. in political science, and received a J.D. from Duke Law School in 1981. Her professional experience includes law, finance and taxation, and she publishes frequently in these areas.

TABLE OF CONTENTS

Detailed Analysis

I. Purpose and General Application of § § 1245 and 1250

A. Historical Background

1. Development of the Loophole

2. Pre-1962 Attempts to Close the Loophole: Regulations, Rulings, Audits, Litigation, and Legislation

3. Enactment of § § 1245 and 1250

4. Impact of Subsequent Legislation

a. Tax Reform Act of 1969

b. Revenue Act of 1971

c. Tax Reform Act of 1976

d. Revenue Act of 1978

e. Crude Oil Windfall Profit Tax Act of 1980

f. Economic Recovery Tax Act of 1981

g. Tax Equity and Fiscal Responsibility Act of 1982

h. The 1984 Tax Reform Act

i. 1985 Legislation

j. 1986 Tax Reform Act

B. Significance of the Recapture Rules After the 1986 TRA and Subsequent Legislation

C. Recapture Notwithstanding Other Provisions of the Code

D. Relationship to Other Recapture Provisions

1. Prior Application

2. Simultaneous Application

3. Subsequent Application

II. Property Subject to Recapture

A. Relationship Between § § 1245 and 1250

B. Section 1245 Property

1. Personal Property - Tangible and Intangible

a. Local Law Definitions Not Controlling

b. Tangible Personal Property

(1) Property Contained in or Attached to a Building

(2) Assets in the Nature of Machinery

c. Intangible Personal Property

(1) Section 197 Intangible Property

(2) Other Intangible Property; Leaseholds

d. Significance of Investment Credit Property Definition

e. Livestock

2. Real Property

a. General

b. Most Investment Credit Real Property Is § 1245 Property

(1) Property Used as an Integral Part of or in Connection with Specified Activities

(2) Research and Storage Facilities Used in Connection with Specified Activities

(3) Special Purpose Structures

(4) Certain Machinery for Temperature or Humidity Requirements

(5) Elevators and Escalators Placed in Service Before 1987

(6) Single Purpose Agricultural or Horticultural Structures

(7) Qualified Timber Property

(8) Storage Facility Used in Connection with Distribution of Petroleum or Primary Products Thereof

(9) Relationship of § 1245 Property to Investment Credit Real Property

c. Amortization Real Property Is § 1245 Property

(1) Pollution Control Facilities (§ 169)

(2) Section 179 Property

(3) Railroad Grading and Tunnel Bores (Repealed § 185)

(4) Child-Care Facilities (Repealed § 188)

(5) Architectural and Transportation Barrier Removals (§ 190)

(6) Certified Historic Structures (Repealed § 191)

(7) Qualified Tertiary Recovery Projects (§ 193)

(8) Reforestation Expenditures (§ 194)

(9) Leasehold Interests in Real Estate

(10) Expenses for Clean-Fuel Vehicles and Certain Refueling Property

(11) Expenses for Compliance With EPA Sulfur Regulations

(12) Expenses for Certain Refineries

(13) Expenses for Energy Efficient Commercial Buildings

(14) Expenses for Advanced Mine Safety Equipment

C. Section 1245 Recovery Property (ACRS Property)

D. Section 1250 Property

1. General - Real Property that Is Not § 1245 Property or § 1245 Recovery Property

2. Buildings

a. General

b. Exceptions to General Rule that Buildings Are § 1250 Property

3. Inherently Permanent Structures or Structural Components

a. General

b. “Inherently Permanent” Versus “Not Inherently Permanent” Structures

c. Structural Components of Buildings or Other Inherently Permanent Structures

4. Land and Improvements

5. Intangible Interests in Real Property - Leaseholds

III. Dispositions That Trigger § § 1245 and 1250

A. Transactions Resulting in Recapture

1. Sales, Taxable Exchanges, Involuntary Conversions, and Other “Dispositions”

2. Transactions Generally Tax-Free in the Absence of § § 1245 and 1250

a. Transferee's Basis Is Cost or Fair Market Value

b. Transferee's Basis Determined by Basis of Other Property

B. Transactions in Which Potential Recapture Is Limited or Postponed

1. Tax-Free Carryovers

a. Gifts

(1) Transfers in Trust

(a) Grantor Treated as Owner

(b) Subsequent Dispositions by Trust

(c) Distributions to Beneficiaries

(2) Part Sale, Part Gift Transactions

(3) Charitable Gifts

b. Section 332 Liquidations

c. Transfers to a Corporation Under § 351

d. Corporate Reorganizations (§ 361)

e. Receivership and Bankruptcy Reorganizations (Repealed § 371)

f. Railroad Reorganizations (Repealed § 374)

g. Transfers to a Partnership Under § 721

h. Distributions from a Partnership Under § 731

2. Tax-Free Rollovers

a. Section 1031 Like-Kind Exchange

b. Section 1033 Involuntary Conversions

c. Transfer of Principal Residence (§ 121 and Repealed § 1034)

d. Low-Income Housing Projects (Repealed § 1039)

e. FCC Transfers (Repealed § 1071) and SEC Transfers (Repealed § 1081)

C. Transactions in Which Potential Recapture Is Completely Forgiven

1. Transfers at Death

a. Income in Respect of a Decedent

b. Pre-Death Transfers Included in Gross Estate

2. Principal Residence

3. Certain § 1250 Property Held for a Sufficiently Long Period of Time

IV. Amount Subject to Recapture

Introductory Material

A. Allocation of Amount Realized in Dispositions Involving Both § 1245 and § 1250 Property

1. Dispositions of § 1245 Property and Non-§ 1245 Property

2. Dispositions of § 1250 Property and Non-§ 1250 Property

B. Gain Limitation

1. Sales, Exchanges, and Involuntary Conversions

a. Sales

b. Exchanges

c. Involuntary Conversions

2. Other Dispositions

a. General

b. Corporate Distributions

(1) Dividend Distributions

(2) Redemptions and Liquidations

c. Section 338 Stock Sales

C. Depreciation Limitation

1. General

a. Type of Deduction

(1) Section 1245

(2) Section 1250

b. Effective Dates and Dates of Service that “Straddle” Effective Dates

(1) Section 1245

(2) Section 1250

c. Allowed or Allowable Rule

d. No Tax Benefit Rule

e. Capitalized Depreciation

f. Rents Excluded

g. Royalties

h. Other Expense Items Excluded

i. Inventory

j. Retired or Demolished Property

2. Section 1245 Property

a. Depreciation Adjustments Subject to Recapture

b. Amortization Adjustments Subject to Recapture

(1) General

(2) Emergency Facilities Under Former § 168

(3) Pollution Control Facilities Under § 169

(4) Section 179 Property

(5) Railroad Rolling Stock Under Former § 184

(6) Railroad Grading and Tunnel Bores Under Former § 185

(7) Child-Care Facilities Under Former § 188

(8) Architectural and Transportation Barrier Removals Under § 190

(9) Certified Historic Structures Under Former § 191

(10) Qualified Tertiary Recovery Projects Under § 193

(11) Reforestation Expenditures Under § 194

(12) Expenses for Clean-Fuel Vehicles and Certain Refueling Property

(13) Expenses for Compliance with EPA Sulfur Regulations

(14) Expenses for Certain Refineries

(15) Expenses for Energy Efficient Commercial Buildings

(16) Expenses for Advanced Mine Safety Equipment

c. Amortization of Leasehold Costs or Improvements

3. Section 1245 Recovery Property

4. Section 1250 Property

a. General - “Additional Depreciation”

b. Property Held One Year or Less

c. Property Held More Than One Year

d. Computation of Depreciation in Excess of Straight-Line

(1) Aggregate, Not Annual, Computation

(2) Useful Life and Salvage Value

(a) Useful Life/Salvage Value Not Required by Method of Depreciation

(b) Effect of Change in Method of Depreciation or Redetermination of Useful Life/Salvage Value

(3) Property Held Before 1964

(a) January 1, 1964, Adjusted Basis

(b) Pre-1964 “Decelerated” Method of Depreciation

(4) Property Held Before 1970; After 1969 and Before 1976; and After 1975

(a) January 1, 1970, and January 1, 1976, Adjusted Basis

(b) Pre-1970 and Pre-1976 “Decelerated” Method of Depreciation

(c) Effect of Post-1969 Deficit in Depreciation

(5) Effect of Recovery Period for ACRS and MACRS Property

e. Amortization Adjustments Subject to Recapture

(1) Determination of “Would Have Been” Amount for Leasehold Interests and Certain Leasehold Improvements

(2) Renewal Period Limitation (Two-Thirds of Amortization Period Used vs. Useful Life)

f. Rehabilitation Expenditures Subject to Recapture

5. Meaning and Significance of Term “Reflected in” Adjusted Basis

a. Depreciation or Amortization Taken by Other Taxpayers or for Other Property

(1) General

(2) Other Taxpayers - Carryover Basis

(3) Other Property - Substituted Basis

(4) Other Taxpayers and Other Property

(5) ACRS “Finance Lease” Property Acquired by Lessee

b. Amount of Depreciation or Amortization “Absorbed” in Completely Taxed Transactions

c. Amount of Depreciation or Amortization “Absorbed” in Transactions Where Recapture Gain Is Not Completely Recognized

(1) General

(2) Tax-Free Carryover (Carryover Basis)

(3) Tax-Free Rollover (Substituted Basis)

(4) Partnership Distributions

(5) Disposition of Principal Residence

(6) Disposition of Qualified Low-Income Housing

d. Tax-Free Transactions in Which the Depreciation Limitation Technically Is Not “Reflected in” Adjusted Basis

(1) Involuntary Conversions

(2) Part Sale, Part Gift Transactions

(3) Partnership Distributions

(4) Former § 1039 Transactions

e. Part Sale, Part Gift Transfers to Charities

f. Special Rule for Transfers at Death

g. Recapture Property in Multiple Asset Accounts

h. Multiple Properties Transferred or Acquired Pursuant to Tax-Free Rollovers

i. Effect of Alternative Minimum Tax Adjustments and Tax Preference Items

(1) Depreciation and Amortization on Certain Property Placed in Service Before 1987 as Tax Preference Items

(2) Depreciation on Property Placed in Service After 1986 as Adjustment in Computing Alternative Minimum Tax

(3) Minimum Tax Credit to Offset Potential Double Taxation

(4) Reduction of Certain Corporate Tax Preference Items

j. Relationship to Other Recapture Sections

D. Applicable Percentage and Holding Period - Section 1250 Property

1. Holding Period - General

a. Beginning of Holding Period

(1) Acquired Property

(2) Constructed Property

b. End of Holding Period

2. Determination of “Full Month”

3. Property with a Transferred Basis

4. Principal Residence

5. Qualified Low-Income Housing

6. Subsequent Increase in Basis

7. Foreclosure Proceedings

8. Applicable Percentage

a. Pre-1970 Percentage

b. Post-1969, Pre-1976 Percentage

(1) Written Contract on July 24, 1969 - 120 Months

(2) Certain Government Assisted or Insured Housing - 120 Months

(3) Residential Rental Property - 200 Months

(4) Rehabilitation Expenditures - 200 Months

c. Post-1975 Percentage

(1) Certain Government Assisted or Insured Housing - 200 Months

(2) Low-Income Dwelling Units - 200 Months

(3) Rehabilitation Expenditures - 200 Months

(4) Title V Loan Property - 200 Months

(5) Residential Rental Property

d. Examples

V. Multiple Classes, Items, or Elements of Property

A. Multiple Classes of Property

1. Fair Market Value Allocation Rule

a. Allocation Agreement Between Buyer and Seller Can Control

b. Allocation in the Absence of Agreement

c. Part Sale, Part Gift Transactions

2. Tax-Free Carryover Boot Allocation Rule

a. Boot Allocation Rule

b. Illustration of Boot Allocation Rule

3. Tax-Free Rollover Replacement Allocation Rule

a. Replacement Allocation Rule

b. Illustrations of the Replacement Allocation Rule

4. Comparison of Boot Allocation and Replacement Allocation Rules

B. Multiple Items of Property

1. General

2. ACRS Property

3. MACRS Property

4. Section 197 Intangibles

C. Allocation of Depreciation (or Cost Recovery) and Adjusted Basis Among Classes or Items of Property

1. “Nonrecovery Property” (Property Other Than ACRS and MACRS Property)

2. ACRS Property

3. MACRS Property

D. The Player Contracts Amalgamation Rule - Former § 1245(a)(4)

1. Depreciation Limitation

2. Gain Limitation

3. Former § 1056

E. Multiple Elements of Nonrecovery (Non-ACRS and Non-MACRS) Property

1. Elements of § 1250 Property

a. Units

b. Separate Improvements

c. Remaining Property

d. Special Elements

e. Low-Income Housing Elements

2. Computation of § 1250 Gain for Property with Two or More Elements

VI. Methods of Accounting

Introductory Material

A. Methods of Depreciation or Cost Recovery

1. Present Value

2. Cross-Over

B. Multiple Asset Accounts, Mass Asset Accounts, and General Asset Accounts

1. Multiple Asset Accounts for Nonrecovery (Non-ACRS and Non-MACRS) Property

a. General

b. ADR or Class-Life System

2. ACRS and MACRS Property

a. General

b. Mass Asset Accounts of ACRS Property

c. General Asset Accounts of MACRS Property

C. Installment Sales

1. Sales Occurring on or Before June 6, 1984

2. Sales Occurring After June 6, 1984

D. Open and Closed Transactions

E. Cash Method

F. Income in Respect of a Decedent

G. Other Transactions

VII. Special Effects of § § 1245 and 1250

Introductory Material

A. General

1. Changes in Methods of Depreciation

2. Sections 108 and 1017

3. Charitable Contributions

4. Exempt Organizations

a. Contributed Property

b. Certain Transfers of Property (Other Than Contributions) to Exempt Organizations

c. Dispositions of Property by Exempt Organizations

d. Conversion of Taxable Entity to Tax-Exempt Entity

5. Deductibility of Capital Losses

6. Net Operating Loss and Recapture

7. Recapture on Dispositions of Entire Interest in Passive Activity

8. Section 267(d) Transactions

9. Investment Tax Credit

10. Exempt Income

11. Relationship to Other Sections - Nonrecognition Sections Overridden

a. Section 1248

b. Certain Nonliquidating Distributions Occurring Before 1989

c. Certain Liquidations Occurring Before 1989

d. Section 931, “Income from Sources Within Guam, American Samoa, or the Northern Mariana Islands”

e. Section 1381

12. Other Corporate Effects

a. Earnings and Profits

b. Personal Holding Company Income

c. Effect on Accumulated Earnings Tax Computation

d. Election and Termination of Election by Corporation to Be Taxed as an S Corporation

e. Taxable Liquidating Distributions Occurring After 1986

13. Records

B. Section 1245

1. Percentage Depletion

a. Section 1245 Gain Properly Allocable to Mining Property

b. Excess of § 1245 Recapture over Expenses

c. Disposition of Mineral Property Before § 1245 Property or § 1245 Recovery Property

d. Records to be Kept

2. Salvage Value

VIII. Tax Planning

Introductory Material

A. Acquisition of Property

1. Section 1245 Property

2. Section 1250 Property

3. Short-Lived Depreciable Property

4. Inventory

B. Accounting for Depreciable Property

1. General

a. Methods of Depreciation or Cost Recovery

b. Installment Sales

c. Multiple Asset Accounts, Mass Asset Accounts (ACRS Property), and General Asset Accounts (MACRS Property)

d. Expensed v. Capitalized Costs

2. Records

C. Dispositions of Property

1. Taxable Dispositions

a. Techniques for Reducing Gain on Dispositions of Property Subject to § 1245

b. Techniques for Reducing Gain on Dispositions of § 1250 Property

c. Corporate Distributions of Depreciable Property

d. Depreciable Property Used for Business and Personal Purposes

2. Tax-Free Transactions


WORKING PAPERS

Working Papers

Table of Worksheets

Worksheet 1 Property Generally Subject to § § 1245 and 1250

Worksheet 2 Section 1245 Computation

Worksheet 3 [Reserved]

Worksheet 4 [Reserved]

Worksheet 5 [Reserved]

Worksheet 6 [Reserved]

Worksheet 7 [Reserved]

Worksheet 8 [Reserved]

Worksheet 9 Illustration of § 1250 Computations for MACRS Property Placed in Service after 1986

Worksheet 10 Comparison of § 1245 and § 1250 Computations

Worksheet 11 Recapture on an Installment Sale Occurring after June 6, 1984

Worksheet 12 S. Rep. No. 1881, 87th Cong., 2d Sess. 95–101, 280–289 (1962)

Worksheet 13 H.R. Rep. No. 749, 88th Cong., 1st Sess. A148–A168 (1963)

Worksheet 14 S. Rep. No. 830, 88th Cong., 2d Sess. 131–139 (1964)

Worksheet 15 S. Rep. No. 830, 88th Cong., 2d Sess. 40–45 (1964)

Worksheet 16 H.R. Rep. No. 413 (Part 1), 91st Cong., 1st Sess. 165–167 (1969)

Worksheet 17 H.R. Rep. No. 413 (Part 2), 91st Cong., 1st Sess. 116–120 (1969)

Worksheet 18 S. Rep. No. 552, 91st Cong., 1st Sess. 99–100, 211–215, 251 (1969)

Worksheet 19 H.R. Rep. No. 782 (Conference Report), 91st Cong., 1st Sess. 320–322 (1969)

Worksheet 20 H.R. Rep. No. 658, 94th Cong., 1st Sess. 85–88, 115–118 (1975)

Worksheet 21 S. Rep. No. 938, 94th Cong., 2d Sess. 40–44 (1976)

Worksheet 22 General Explanation of the Tax Reform Act of 1976, Prepared by the Staff of the Joint Committee on Taxation, 29–32, 82–87 (12/29/76)

Worksheet 23 H.R. Rep. No. 1515 (Conference Report), 94th Cong., 2d Sess. 408, 410 (1976)

Worksheet 24 S. Rep. No. 1263, 95th Cong., 2d Sess. 115–117 (1978)

Worksheet 25 H.R. Rep. No. 1800 (Conference Report), 95th Cong., 2d Sess. 226–228 (1978)

Worksheet 26 General Explanation of the Economic Recovery Tax Act of 1981 Prepared by the Staff of the Joint Committee on Taxation, 67–86 (12/29/81)

Worksheet 27 S. Rep. No. 144, 97th Cong., 1st Sess. 39–41, 47–49, 53–54 (1981)

Worksheet 28 H.R. Rep. No. 215 (Conference Report), 97th Cong., 1st Sess. 209–210 (1981)

Worksheet 29 S. Rep. No. 494, 97th Cong., 2d Sess. 122–123 (1982)

Worksheet 30 H.R. Rep. No. 861 (Conference Report), 98th Cong., 2d Sess. 1008–1009 (6/23/84)

Worksheet 31 General Explanation of the Tax Reform Act of 1986 Prepared by the Staff of the Joint Committee on Taxation, 89–110 (5/4/87)

Worksheet 32 H.R. Rep. No. 841 (Conference Report), 99th Cong., 2d Sess. II–47, II–48, II–845 (1986)

Bibliography

OFFICIAL

Statutes:

Treasury Regulations:

Proposed and Temporary Regulations:

Committee Reports:

Joint Committee on Taxation Staff Publications:

Treasury Rulings:

Cases:

UNOFFICIAL

Periodicals:

1963

1965

1986

1988

1989

1990

1991

1992

1993

1994

1996

1998

1999