Property Transactions: Dispositions of Trade or Business ... · PDF filegain. If there is a net loss, it is treated as an ordinary loss. In short, § 1231 allows taxpayers to have

Property Transactions: Dispositions of Trade or Business Property

17

Learning ObjectivesUpon completion of this chapter you will be able to:

Chapter Outline

LO.1 Trace the historical development of the special tax treatment allowed for dispositions of trade or business property.

LO.2 Define § 1231 property

LO.3 Apply the § 1231 gain and loss netting process to a taxpayer’s § 1231 asset transactions

LO.4 Explain the purpose of the depreciation recapture rules

LO.5 Compute depreciation recapture under § 1245

LO.6 Compute depreciation recapture under § 1250

LO.7 Explain the additional recapture rule applicable only to corporate taxpayers

LO.8 Identify tax planning opportunities related to sales or other dispositions of trade or business property

Introduction 17-2Section 1231 17-2 Historical Perspective 17-2 Section 1231 Property 17-3 Other § 1231 Property 17-4 Section 1231 Netting Process 17-6 Look-Back Rule 17-10 Applicability of Lower Rates 17-11Depreciation Recapture 17-13 Historical Perspective 17-13 When Applicable 17-14 Types of Depreciation Recapture 17-14 Full Recapture—§ 1245 17-15 Partial Recapture—§ 1250 17-17 Additional Recapture— Corporations 17-35 Other Recapture Provisions 17-36

Related Business Issues 17-38 Installment Sales of Trade or Business Property 17-38 Intangible Business Assets 17-39 Dispositions of Business Assets and the Self-Employment Tax 17-39Tax Planning Considerations 17-40 Timing of Sales and Other Dispositions 17-40 Selecting Depreciation Methods 17-40 Installment Sales 17-41 Sales of Businesses 17-41 Dispositions of Business Assets and the Self-Employment Tax 17-41Problem Materials 17-42

17-1

17-2 Chapter 17 Property Transactions: Dispositions of Trade or Business Property

Introduction

As is no doubt clear by now, the treatment of property transactions is a complex story that seeks to answer three questions: (1) What is the gain or loss realized? (2) How much is recognized? and (3) What is its character? This chapter, the final act in the property transac-tion trilogy, addresses the problems in determining the character of gains or losses on the dispositions of property used in a trade or business.

In an uncomplicated world, it might seem logical to assume that gains or losses from property dispositions—be it stock, equipment, buildings, or whatever—would be treated just like any other type of income or deduction. But, as shown in the previous chapter, treat-ing all items alike apparently was not part of the grand plan. Congress forever changed the process with the institution of preferential treatment for capital gains in 1921. Since that time taxpayers have been required to determine not only the gain or loss realized and rec-ognized but also whether a disposition involved a capital asset. It is important to understand that these rules did not simply tip the scales in favor of capital gain. In the interest of fair-ness and equity, they also established a less than friendly environment for capital losses. The limitations on the deductibility of capital losses is clearly a major disadvantage, particularly considering that ordinary losses are fully deductible. The end result of Congress’s handi-work was the creation of a system in which the preferred result is capital gain treatment for gains and ordinary treatment for losses. This chapter contains the saga of what happens when Congress attempts to provide taxpayers with the best of both worlds.

Section 1231

The road to tax heaven—capital gain and ordinary loss—begins at § 1231 (in tax parlance properly pronounced as “twelve thirty-one”). While § 1231 can be a completely bewilder-ing provision, its basic operation is relatively simple. At the close of the taxable year, the taxpayer nets all gains and losses from so-called § 1231 property (e.g., land and depreciable property used in a trade or business). If there is a net gain, it is treated as a long-term capital gain. If there is a net loss, it is treated as an ordinary loss. In short, § 1231 allows taxpayers to have their cake and eat it, too. Unfortunately, this is accomplished only with a great deal of complexity, much of which makes sense only if the historical events that shaped § 1231 are considered.

Historical PersPective

At first glance, it seems that the productive assets of a business—its property, plant, and equipment—would be perfect candidates for capital gain treatment and would therefore be considered capital assets. Indeed, that was exactly the case initially. From 1921 to 1938, real or depreciable property used in business was in fact treated as a capital asset. At that time, the classification of such property as a capital asset seemed not only appropriate but desirable—particularly as the economy grew during the early 1920s and taxpayers were realizing gains. However, the opposite became true with the onset of the Great Depression. As the economy deteriorated, businesses that had purchased assets at inflated prices dur-ing the booming 1920s found themselves selling such properties at huge losses during the depression-plagued 1930s. To make matters worse, the tax law treated such losses as capi-tal losses, severely limiting their deduction. But Congress apparently had a sympathetic ear for these concerns. Hoping that a change would help stimulate the economy, Congress enacted legislation that removed business properties from the list of capital assets. The legislative history to the Revenue Act of 1938 provides some insight into Congressional thinking, explaining that “corporations will not, as formerly, be deterred from disposing of partially obsolescent property, such as machinery or equipment, because of the limitations imposed … upon the deduction of capital losses.”1 With the 1938 changes in place, business got the ordinary loss treatment it wanted but at the same time was saddled with ordinary income treatments for its gains.

LO.1Trace the historical development of the special tax treatment allowed for dispositions of trade or business property.

1 House Ways and Means Committee, H.R. Rep. 1860, 75th Cong., 3d Sess. (1938).

Section 1231 17-3

Although these rules worked well during the Depression years as businesses were re-porting losses, they produced some unduly harsh results once the country moved to a war-time economy. By 1942, the build-up for World War II had the economy humming and inflation had once again set in. Businesses that earlier had sold assets for 10 cents on the dollar now found themselves realizing gains. Of course, under the 1938 changes these gains no longer benefited from preferential treatment but were taxed at extraordinarily high tax rates (88 percent for individuals and 40 percent for corporations). The shipping industry was particularly hard hit by the new treatment. Shippers not only had gains as the enemy destroyed their insured ships but also profited when they were forced to sell their property to the government for use in the war. Other businesses that had their factories and equip-ment condemned and requisitioned also felt the sting of higher ordinary rates. Although these companies could have deferred their gains had they replaced the property under the involuntary conversion rules of § 1033, qualified reinvestment property was in short supply, making § 1033 virtually useless. Understanding the plight of business, Congress once again came to the rescue. In 1942, Congress enacted legislation generally reinstating capital gain treatment but preserving ordinary loss treatment.

The changes in 1942 stemmed primarily from a need to provide relief for those whose property was condemned for the war effort. But in the end they went much further. For con-sistency, capital gain treatment was extended not only to condemnations of a business prop-erty but to other types of involuntary conversions as well. Under the new rules, casualty and theft gains from business property and capital assets also received capital gain treatment. In addition, the new legislation unexpectedly extended capital gain treatment to regular sales of property, plant, and equipment. Apparently, Congress felt that capital gain treatment was also appropriate for taxpayers who were selling out in anticipation of condemnation or simply because wartime conditions had made operations difficult. While Congress thought capital gain treatment was warranted for these gains, it also knew that other businesses had not profited from the war and were still suffering losses from their property transactions. Accordingly, it acted to preserve ordinary loss treatment. The end result of these maneuvers was the enactment of § 1231, an extremely complex provision that provides taxpayers with the best of all possible tax worlds: capital gain and ordinary loss.

The product of Congressional tinkering in 1942 still remains today. To summarize, real and depreciable property used in a trade or business is specifically denied capital asset sta-tus. But this does not necessarily mean that such property will be denied capital gain treat-ment. As explained at the outset, § 1231 generally extends capital gain treatment to gains and losses from these assets if the taxpayer realizes a net gain from all § 1231 transactions. On the other hand, if there is a net loss, ordinary loss treatment applies. But this summary lacks a great deal of precision. The specific rules of § 1231 are described below.

section 1231 ProPerty

The special treatment of § 1231 is generally granted only to certain transactions involving assets normally referred to as § 1231 property.2 Section 1231 property includes a variety of assets, but among them the most important is real or depreciable property that is used in the taxpayer’s trade or business and that is held for more than one year.3 This definition takes in most items commonly identified as a business’s fixed assets, normally referred to as its property, plant, and equipment. For example, the reach of § 1231 includes depreciable personal property used in business, such as machinery, equipment, office furniture, and business automobiles. Similarly, realty used in a business, such as office buildings, ware-houses, factories, and farmland, is also considered § 1231 property.

LO.2Define § 1231 property

2 As explained below, § 1231 also applies to involuntary conversions of pure capital assets held more than one year that are used in a trade or business or held for investment. Involuntary conversions by theft or casualty of personal assets are not included under § 1231 but are subject to a special computation.

3 The holding period is determined in the same manner as it is for capital assets. See § 1223 discussed in Chapter 16.


The Code specifically excludes the following assets from § 1231 treatment:

1. Property held primarily for sale to customers in the ordinary course of a trade or busi-ness, or includible in inventory, if on hand at the close of the tax year;

2. A copyright; a literary, musical, or artistic composition; a letter or memorandum; or similar property held by a taxpayer whose personal efforts created such property or by certain other persons; or

3. A publication of the United States Government received from the government other than by purchase at the price at which the publication is offered to the general public.4

Note that the excluded assets are also excluded from the definition of a capital asset. As a result, gains or losses on the disposition of inventory, property held primarily for resale, literary compositions, and certain government publications always yield ordinary income or ordinary loss.

One of the critical conditions for § 1231 treatment requires that the property be used in a trade or business. Although this test normally presents little difficulty, from time to time it has created problems, particularly for those with rental property. As an illustration, consider the common situation of a taxpayer who sells rental property such as a house, duplex, or apartment complex. Is the property sold a capital asset or § 1231 property? If a taxpayer sells rental property at a gain, the gain would normally receive capital gain treat-ment regardless of whether the property is a capital asset or § 1231 property. On the other hand, if the taxpayer sells the rental property at a loss, § 1231 treatment is usually far more desirable. Although the Code does not provide any clear guidance on the issue, the courts have generally held that property used for rental purposes is considered as used in a trade or business and is therefore eligible for § 1231 treatment.5

otHer § 1231 ProPerty

From time to time, Congress has been convinced that particular industries deserve special tax relief. As a result, it has added a number of other properties to the § 1231 basket. Those eligible for capital gain and ordinary loss are:

1. Timber, coal, and iron ore to which § 631 applies;6

2. Unharvested crops on land used in a trade or business and held for more than one year;7 and

3. Certain livestock.8

TimberUnder § 631, the mere cutting of timber by the owner of the timber, or by a person who has the right to cut the timber and has held the timber or right more than one year, is to be treated, at his or her election, as a sale or exchange of the timber that is cut during the year. The timber must be cut for sale or for use in the taxpayer’s trade or business. In such case, the taxpayer would report a § 1231 gain or loss and potentially receive capital gain treat-ment for what otherwise might be considered the taxpayer’s inventory—a very favorable result. It may appear that the timber industry has secured an unfair advantage, but timber’s eligibility is arguably justified on the grounds that the value of timber normally accrues incrementally as it grows over a long period of time.

The amount of gain or loss on the “sale” of the timber is the fair market value of the tim-ber on the first day of the taxable year minus the timber’s adjusted basis for depletion. For all subsequent purposes (i.e., the sale of the cut timber), the fair market value of the timber as of the beginning of the year will be treated as the cost of the timber. The term timber not only includes trees used for lumber and other wood products, but also includes evergreen trees that

4 § 1231(b)(1).5 See, for example, Mary Crawford, 16 T.C. 678 (1951) A.

1951-2 C.B. 2, and Gilford v. Comm., 53-1 USTC ¶9201, 43 AFTR 221, 201 F.2d 735 (CA-2, 1953).

6 § 1231(b)(2).7 § 1231(b)(4).8 § 1231(b)(3).

Section 1231 17-5

are more than six years old when cut and are sold for ornamental purposes (e.g., Christmas trees).9

Example 1

B owned standing timber that he had purchased for $250,000 three years earlier. The timber was cut and sold to a lumber mill for $410,000 during 2012. The fair market value of the standing timber as of January 1, 2012 was $320,000. B has a § 1231 gain of $70,000 if he makes an election under § 631 ($320,000 fair market value of the timber on the first day of the taxable year less its $250,000 adjusted basis for deple-tion). The remainder of his gain on the actual sale of the timber, $90,000 ($410,000 selling price − $320,000 new “cost” of the timber), is ordinary income. Any expenses incurred by B in cutting the timber would be deductible as ordinary deductions.

An election under § 631 with respect to timber is binding on all timber owned by the taxpayer during the year of the election and in all subsequent years. The IRS may permit revocation of such election because of significant hardship. However, once the election is revoked, IRS consent must be obtained to make a new election.10

Section 631 also applies to the sale of timber under a contract providing a retained eco-nomic interest (i.e., a taxpayer sells the timber, but keeps the right to receive a royalty from its later sale) for the taxpayer in the timber. In such a case, the transfer is considered a sale or exchange. The gain or loss is recognized on the date the timber is cut, or when payment is received, if earlier, at the election of the taxpayer.11

Coal and Iron OreWhen an owner disposes of coal or domestic iron ore under a contract that calls for a re-tained economic interest in the property, the disposition is treated as a sale or exchange of the coal or iron ore. The date the coal or ore is mined is considered the date of sale and since the property is § 1231 property, the gain or loss will be treated under § 1231.12

The taxpayer may not be a co-adventurer, partner, or principal in the mining of the coal or iron ore. Furthermore, the coal or iron ore may not be sold to certain related taxpayers.13

Unharvested CropsSection 1231 also addresses the special situation where a farmer sells land with unharvested crops sitting upon the land. In this case, it seems logical that the farmer should allocate the sales price between the crops and the land to ensure ordinary income or loss for the sale of the farmer’s inventory and capital gain or ordinary loss on the sale of the land. While this may be the theoretically correct result, Congress wanted to eliminate potential controversy over the allocation. Accordingly, for administrative convenience it brought the entire trans-action into the § 1231 fold in 1951. Currently, whenever land used in a trade or business and unharvested crops on that land are sold at the same time to the same buyer, the gain or loss is subject to § 1231 treatment as long as the land has been held for more than a year.14

It is worth noting that the benefits of § 1231 were not extended to farmers free of charge. At the same time, Congress eliminated the current deduction for production expenses. The law now provides that any expenses related to the production of crops cannot be deducted currently but must be capitalized as part of the basis of the crops.15 Such treatment, in a year when land and crops are sold, reduces the farmer’s capital gain on the sale rather than any other ordinary income.

9 § 631(a).

10 Ibid.

11 § 631(b).12 § 631(c).

13 §§ 631(c)(1) and (2).14 § 1231(b)(4).15 § 268.


Example 2

F sold 100 acres of land used in his farming business just days before the corn on the land was harvested. For the “package” deal, he received $600,000, including an esti-mated $70,000 for the unharvested crops that he figured had cost $20,000 to produce. F had purchased the land in 2000 for $200,000. In determining the character of his gain, F is not required to allocate the sales price between the crops and the land since he sold both at the same time to the same buyer, therefore qualifying for § 1231 treat-ment. He will recognize a § 1231 gain of $380,000 computed as follows:

Sales price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $600,000Adjusted basis ($200,000 1 $20,000) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . −220,000

§ 1231 gain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $380,000

Note that F has effectively turned the $50,000 ($70,000 − $20,000) profit from the sale of his crops from ordinary income into potential capital gain.

LivestockLivestock that are used for breeding and other income producing purposes are depreciable assets much like machinery and thus qualify for § 1231 treatment. In many situations, how-ever, livestock are used for these purposes for only a short period of time and then sold. If this is the farmer’s or rancher’s normal practice, the IRS is inclined to argue that the animals are held primarily for resale, in which case the law specifically denies § 1231 treatment. To help end this controversy, Congress specifically made all livestock (other than poultry) used for draft, breeding, dairy, or sporting purposes eligible for § 1231 treatment if they are held for over a year.16 In the case of cattle and horses, the holding period is extended to two years. Note that this treatment is extremely beneficial since the taxpayer effectively gets capital gain from animals pulled out of the breeding process and sold. Moreover, the farmer or rancher is allowed to deduct the costs of raising such animals currently against ordinary income. The extension of the holding period for cattle and horses was in part, an attempt to cut back on the benefits of this favorable treatment.

section 1231 netting Process

The treatment of § 1231 gains or losses ultimately depends on the outcome of a netting pro-cess that is far more complicated than outlined earlier.17 As can be seen from the flowchart in Exhibit 17.1, the taxpayer must first identify all of the gains and losses that enter into the netting process. These include gains and losses from what has been described above as § 1231 property. Also, the § 1231 “bucket” includes involuntary conversions of certain capi-tal assets. Surprisingly, gains or losses recognized from casualties, thefts, or condemnations of capital assets that are used in a trade or business or held for investment are part of the § 1231 netting process. Involuntary conversions of capital assets that are held for personal use are not considered under § 1231 but are subject to special rules.

After identifying all of the § 1231 transactions, the taxpayer must segregate the § 1231 gains and losses arising from casualty and theft from those attributable to sale, exchange, and condemnation. The end result is that there are two sets of § 1231 transactions:

1. Involuntary conversions due to casualty and theft of:

• § 1231 property

• Real and depreciable property used in business and held more than one year

• Timber, coal, iron ore, unharvested crops, and livestock

• Capital assets

• Used in a trade or business or held for investment in connection with business and held more than one year

LO.3Apply the § 1231 gain and loss netting process to a taxpayer’s § 1231 asset transactions.

16 § 1231(b)(3). 17 § 1231(a).

Section 1231 17-7

2. Sales and exchanges of:


• Real and depreciable property used in business

• Timber, coal, iron ore, unharvested crops and livestock

Involuntary conversion due to condemnation of:


• Real and depreciable property used in business and held more than one year

• Timber, coal, iron ore, unharvested crops, and livestock

• Capital assets

• Used in a trade or business or held for investment in connection with business and held more than one year

EXHIBIT 17.1 Section 1231 Netting Process

Casualty and theft gains*and losses from §1231assets and specified

capital assets

Gains* and losses from sales orexchanges of § 1231 assets

and specified involuntaryconversions

Net(Step 1)

IfLoss

IfGain

Net(Step 2)

IfLoss

IfGain

IfYes

IfNo

Treat gains and lossesseparately: gains are

ordinary income: businesslosses are deductions

for A.G.I.: otherlosses are deductions

from A.G.I.

Treat net resultas an ordinary

deduction

Look-Back Rule:Did the taxpayerdeduct any net

§ 1231 losses inthe last five

taxable years?

Treat entirenet gain as a15% or 28%capital gain

Treat as ordinary incomethe lesser of

(1) unrecaptured § 1231losses, or (2) the currentyear’s net gain. Treat any

excess § 1231 gain as 15%or 28% capital gain

* Gains remaining after reduction for any depreciation recapture


Within each of these two categories, each gain and loss is assigned to one of the three potential long-term capital gain groups and netted just as if they had been 28%, 25% or 15% capital gains or losses (see Chapter 16). This means that each § 1231 gain or loss is assigned to one of the following categories: (1) 15% group for § 1231 gains and losses (15G or 15L); (2) 25% group for unrecaptured § 1250 depreciation on gains from § 1231 assets (25G discussed below); and (3) 28% group for gains and losses from collectibles (28G or 28L). Once all of the appropriate transactions have been poured into the § 1231 process, the netting process can begin. There are three steps.

1. First, all of the gains and losses in the first category of § 1231 transactions (casualties and thefts) are netted. Specifically, gains and losses within the 15% and 28% groups are netted to arrive at one of the following: (1) a net gain or loss on 15% § 1231 assets (N15G or N15L); and (2) a net gain or loss on 28% § 1231 assets (N28G or N28L). Any net loss positions are then combined with the net gain positions using the rules discussed for netting the three groups for capital asset transactions:

• A N28L first offsets 25G, then N15G.

• A N15L first offsets a N28G, then 25G.

• There can be no net loss in the 25G group since this group contains only gains.

This netting process is summarized as follows:

Section 1231 Gains and Losses from Casualty and Theft

CollectiblesUnrecaptured Depreciation Other

28% 25% 15%

Gains . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $x,xxx Gains only $xx,xxx

Losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (x,xxx) – (x,xxx)

Net gain or loss . . . . . . . . . . . . . . . . . . . . . . ???? Gain only ????

Possibilities:

1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . N28G 25G N15G

2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . N28G 25G N15L

3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . N28L 25G N15G

4 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . N28L 25G N15L

If the netting process results in a net gain position(s) (e.g., a N28G, N25G, and a N15G) the net gains from casualties and thefts become § 1231 gains and become part of the second cate-gory of other § 1231 transactions (each assigned to either the 28%, 25%, or 15% groups).

Example 3

During the year, T, who is in the 35% tax bracket, reported the following § 1231 gains and losses from casualties of § 1231 assets (including casualties of capital assets used in a trade or business) and netted them as shown below.

Section 1231 Gains and Losses


28% 25% 15%

Gains . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,000 $4,000 $ 2,000

Losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . (4,000)

—

(7,000)

Net gain or loss . . . . . . . . . . . . . . . . . . . . . $ 6,000 $4,000 ($ 5,000)

Netting . . . . . . . . . . . . . . . . . . . . . . . . . . . (5,000)

—

5,000

To Section 1231 Other . . . . . . . . . . . . . . . $ 1,000

$4,000

$ 0

T has a N28G of $1,000 and a N25G of $4,000. Since the end results are net gains, each net gain is assigned to its appropriate group in the second category of other § 1231 transactions.

Section 1231 17-9

If a net loss results, the casualty and theft gains and losses are removed from the § 1231 process and treated separately. The gains are treated as ordinary income, and the losses on business use assets are deductible for A.G.I. Any other casualty and theft losses are deduct-ible from A.G.I.

2. The second step of the process is to combine any net casualty or theft gains from the first step with the gains or losses in the second set of § 1231 transactions. In this regard, the net casualty and theft gains must be assigned to the appropriate group (15%, 25%, or 28% group) in the second category of § 1231 transactions (sales and exchanges of § 1231 assets and certain condemnations). For example, if the taxpayer had a net 15% gain from § 1231 casualties, this gain would become a 15% gain in the second category of § 1231 transactions. These transactions are then netted just as if they had been 28%, 25%, or 15% capital gains or losses to determine if there is a net gain or loss.

3. The final step in the § 1231 netting process is to characterize the gain or loss resulting from netting the transactions in the second step. If the net result is a loss, the net loss is treated as an ordinary deduction for A.G.I. It is not treated as a capital loss. If the net result is a gain (e.g., a N25G and a N15G), these gains are normally treated as capital gains and become part of the capital gain and loss netting process.

The § 1231 netting process is illustrated in Exhibit 17.1 above and the following examples.

Example 4

During the current year, D sold real estate used in her business for $45,000. She had purchased the property several years ago for $36,000. D also sold a business car (held for more than 15 months) at a loss of $1,200. D’s gain on the real estate is computed as follows:

Selling price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 45,000Less: Adjusted basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (36,000)

Gain realized and recognized . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 9,000

D nets the gain and loss as follows:

15% Gain from sale of § 1231 asset . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 9,00015% Loss from sale of § 1231 asset . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,200)

Net 15% § 1231 gain for year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 7,800

D’s net 15% § 1231 gain of $7,800 is treated as a 15% capital gain. If she had other capital gains or losses during the year, they will be subject to the capital gain and loss netting process discussed in Chapter 16.

Example 5

During the year R, a sole proprietor, sold a business computer for $32,000. His basis at the time of the sale was $44,000. He also sold land used in his business at a gain of $1,400 and had an uninsured theft loss of works of art used to decorate his busi-ness offices (i.e., capital assets held in connection with a trade or business). R had purchased the artwork for $1,500 and it was valued at $5,000 before the burglary. All of the assets were acquired more than 12 months ago.


R nets his gains and losses as follows:

Step 1: The net loss from the casualty is $1,500 (adjusted basis). Since R has a net 15% casualty loss, it is not treated as a § 1231 loss. Instead, the loss is treated as an ordinary loss (which is fully deductible for A.G.I. since the art works were business property).

Step 2: Combine gains and losses from sales of § 1231 assets:

15% loss from sale of business computer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($12,000)

15% gain from sale of business land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,400

Net § 1231 loss for year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($10,600)

Step 3: A net § 1231 loss is treated as an ordinary deduction. Thus, R’s $10,600 loss can be used to offset other ordinary income.

Note that the theft loss of the works of art is included in the first step of the netting process even though these items are capital assets. This loss would have offset, dollar for dollar, any casualty or theft gains (net of depreciation recapture) from § 1231 as-sets as well as any casualty or theft gains from other capital assets held in connection with R’s business. Also note that the current year’s deductible § 1231 loss may result in a change in the character of any net § 1231 gains in the next five years due to the look-back rule.

look-Back rule

For many years, taxpayers took advantage of the § 1231 netting process. For example, as-sume a taxpayer in the 35 percent tax bracket currently owns two § 1231 assets, both held for 15 months. One asset has a built-in gain of $10,000 and the other has a built-in loss of $9,000. If both assets are sold during the year, the loss offsets the gain and the taxpayer pays a capital gain tax of $150 [($10,000 − $9,000 5 $1,000) 3 15%]. If the taxpayer had sold the assets in different years, the loss would not have reduced the gain, and the tax after both transactions would have been $1,500 in one year ($10,000 3 15%) and $3,150 ($9,000 3 35%) of savings in the other year, for a net tax savings of $1,650 ($3,150 − $1,500). As might be imagined, taxpayers carefully planned their transactions to maximize their tax savings.

In an effort to prevent taxpayers from cleverly timing their § 1231 gains and losses to ensure that § 1231 losses reduced ordinary income and not potential capital gain, Congress enacted the so-called look-back rule in 1984. Under this rule, a taxpayer with a net § 1231 gain in the current year must report the gain as ordinary income to the extent of any un-recaptured net § 1231 losses reported in the past five taxable years.18 In recapturing the § 1231 gains, recapture occurs in the following order: 28% gains, 25% gains, and 15% gains. Unrecaptured net § 1231 losses are simply the net § 1231 losses that have occurred during the past five years that have not been previously recaptured (i.e., the excess of net § 1231 losses of the five preceding years over the amount of such loss that has been recap-tured in the five prior years).

Example 6

Assume the same facts in Example 5 and that R’s 2012 net § 1231 loss of $10,600 is the only loss he has deducted in the past five years. In 2013 (the current year), R has a net 15% § 1231 gain of $15,000. R is subject to the look-back rule since in the prior year he reported a § 1231 loss of $10,600 that has not been recaptured. He must report $10,600 of ordinary income and $4,400 of net 15% § 1231 gain. Should R have a § 1231 gain in the following year, he will not be subject to the look-back rule again since he has recaptured all prior year’s net § 1231 losses.

18 § 1231(c).

Section 1231 17-11

aPPlicaBility of lower rates

Five potential tax rates apply to long-term capital gains while six rates can apply to ordinary income, which includes short-term capital gains.

To ensure that the appropriate rate is applied, the following process should be followed.

• The first step is to complete the § 1231 netting process.

• If there is a net § 1231 loss, that loss must be treated as an ordinary loss and it is left out of the capital gain and loss netting process entirely.

• If there is a net § 1231 gain, it is treated as a long-term capital gain and is entered into the capital gain and loss netting process in the next step. In order to do this, a determination must be made as to which part of the gain, if any, is 25% gain, and which part, if any, is 15% gain.

• Netting of capital gains and losses occurs in each of the various groups of assets.

• Short-term gains are netted against short-term losses and long-term gains are net-ted against long-term losses.

• Within the long-term netting process, gains and losses are further broken down in the various sub-groups with 15% gains and losses, and 28% gains and losses being netted. Since there are no 25% losses, the 25% gains are not reduced.

• The net gains and losses from these three groups are netted against one another as prescribed in Chapter 16 (e.g., 28% losses are first offset against 25% gains, then 15% gains, and 15% losses are first offset against 28% gains, then 25% gains).

• Short-term gains and losses are netted/combined with long-term gains and losses. Short-term losses are first netted against 28% gains, then 25% gains, and finally 15% gains. Net long-term losses are netted against short-term gains.

• The net results are subject to the capital gains tax.

• Short-term gains are treated like ordinary income

• Long-term gains are subject to tax at the appropriate specified capital gains rates (0%, 10%, 15%, 25%, and 28%)

• Losses are subject to the $3,000 annual limit with the excess being carried forward.

Numerous possibilities exist, therefore, for any net § 1231 gain. Perhaps, the gain would be offset by capital losses, receiving no favorable treatment at all. However, if the § 1231 gain survives the netting process to be included in a net capital gain, it is subject to the preferred rates right along with any other long-term capital gains with surviving unrecaptured § 1250 gain being treated as 25% gain and any other surviving gain treated as 15% gain.

cHeck your knowledge

Review Question 1Indicate whether the following gains and losses are § 1231 gains or losses or capital gains and losses or neither. Make your determination prior to the § 1231 netting process and as-sume any holding period requirement has been met.

a. Gain on the sale of General Motors stock held as a temporary investment by Consolidated Brands Corporation.

b. Gain on the sale of a four-unit apartment complex owned by Lorena Smith. This was her only rental property.

c. Loss on the sale of welding machinery used by Arco Welding in its business.

d. Loss on theft of welding machinery used by Arco Welding in its business.

e. Gain on sale of diamond bracelet by Nancy Jones.

f. Income from sale of electric razors by Razor Corporation, which manufactures them.

g. Gain on condemnation of land on which Tonya Smith’s personal residence is built.


h. Gain on condemnation of land owned by Tonya Smith’s business.

i. Loss on sale of personal automobile.

Answer. The § 1231 hodgepodge contains not only gains and losses from § 1231 property but also those from involuntary conversions by casualty, theft, or condemnation of capital assets that are used in a trade or business or held as an investment in connection with a trade or business.

a. The sale of the GM stock is not included in the § 1231 pot since it is a sale of a capital asset and not an involuntary conversion.

b. The rental property is generally considered property used in a trade or business and thus § 1231 property even if the owner owns only a single property.

c. The welding machinery is depreciable property used in a business and is therefore considered § 1231 property.

d. The theft of the welding machinery is also a § 1231 transaction. Note, however, that in processing the § 1231 gains and losses, the casualties must be segregated from the sales.

e. The sale of the diamond bracelet produces capital gain since it is a pure capital asset and not trade or business property.

f. The razors are inventory and are therefore neither capital assets nor § 1231 property.

g. The condemnation of the land near the residence is considered a personal involuntary conversion gain. Since the land is not held in connection with a trade or business, it does not qualify as § 1231 property, but it is a capital asset.

h. The condemnation of the land held for business does enter into the § 1231 hodge-podge as a regular § 1231 gain.

i. Although the personal automobile is a capital asset, no loss is allowed from the sale.

Review Question 2During his senior year at the University of Virginia, Bill decided that he never wanted to leave Charlottesville. After some thought, he opened his own hamburger joint, Billy’s Burgers. That was 20 years ago and Bill has had great success, owning a number of busi-nesses all over Virginia and North Carolina. Not believing in corporations, Bill and his wife, Betty, operate all of these as partnerships.

a. Information from the partnerships and his own personal records revealed the follow-ing transactions during the current year:

1. Sale of one of 50 apartment buildings that one of their partnerships owns: $50,000 gain (ignore depreciation)

2. Sale of restaurant equipment: $20,000 loss Assuming both assets have been held for several years, how should Bill and Betty

report these transactions on their current year return?

Answer. Under § 1231, the taxpayer generally nets gains and losses from the sale of § 1231 property. If a net gain results, the gain is treated as a long-term capital gain, while a net loss is treated as an ordinary loss. For this purpose, § 1231 property generally includes real or depreciable property used in a trade or business. In this case, both the apartment complex and the restaurant equipment are § 1231 property and both are in the 15 percent group. As a result, the couple should net the gain and loss and report a 15 percent capital gain of $30,000.

b. The couple’s records for the following year revealed several gains and losses:

1. Office building burned down: $20,000 loss

2. Crane for bungee jumping business stolen: $35,000 gain (assume no depreciation had been claimed)

3. Parking lot sold: $14,000 loss

4. Exxon stock sold: long-term capital loss of $10,000

5. Condemnation of Greensboro land held for use in the business: $15,000 gain.

Depreciation Recapture 17-13

Assuming each of the assets was held for several years, determine how much 15 percent capital gain or loss as well as the amount of ordinary income or loss that Bill and Betty will report for the year.

Answer. The § 1231 netting process requires the taxpayer to separate § 1231 casualty gains and losses from other § 1231 transactions (sometimes referred to as regular § 1231 items). The casualty loss on the office building and the casualty gain on the crane are both consid-ered § 1231 15 percent casualties since they involve § 1231 property (i.e., real or depreciable property used in business). Note that the condemnation—even though it is an involuntary conversion—is not treated as a § 1231 casualty. The casualty items are netted to determine whether there is a net gain or loss. Here, there is a net casualty 15 percent gain of $15,000 ($35,000 − $20,000). This net gain is then combined with any “regular” § 1231 items, in this case the $14,000 loss on the sale of the parking lot (real property used in a business) and the $15,000 gain on the condemnation of the land (a capital asset). Note that both “regular” § 1231 items are also in the 15 percent group. After netting these items, the partnership has a net gain of $16,000. This $16,000 net § 1231 gain is treated as a 15 percent capital gain and is combined with $10,000 15 percent capital loss on the sale of the stock. The end result is a $6,000 15 percent capital gain. This process can be summarized as follows (see also Exhibit 17.3):

c. Same as in (b), except Bill and Betty reported a net § 1231 loss of $3,000 in the previ-ous year.

Answer. In this case, the look-back rule applies, causing $3,000 of the net 15 percent § 1231 gain to be treated as ordinary income. As a result, the couple’s 15 percent capital gain from the § 1231 netting process is $13,000 and their net 15 percent capital gain is only $3,000.

Depreciation Recapture

Historical PersPective

For many years, taxpayers have taken advantage of the interaction of § 1231 and the de-preciation rules to secure significant tax savings. Prior to 1962 there were no substantial statutory restrictions on the depreciation methods that could be adopted. Consequently, a taxpayer could quickly recover the basis of a depreciable asset by selecting a rapid deprecia-tion method such as declining balance and using a short useful life. If the property’s value did not decline as quickly as its basis was being reduced by depreciation deductions, a gain was ensured if the property was disposed of at a later date. The end result could be quite beneficial.


Example 7

During the current year, T purchased equipment for $1 million. After two years, T, us-ing favorable depreciation rules, had claimed and deducted $600,000 of depreciation, leaving a basis of $400,000. Assume that the property did not truly depreciate in value and T was able to sell it in the third year for its original cost of $1 million. In such case T would report a gain of $600,000 ($1,000,000 − $400,000). Except for time value of money considerations, it appears that the $600,000 gain and the $600,000 of depreciation are simply a wash. However, the depreciation reduced ordinary income that would be taxed at ordinary rates while the gain would be a § 1231 gain and likely taxed at capital gain rates. As an illustration of the savings that could be achieved, assume that the law at this time provided for a top capital gain rate of 20% and the taxpayer’s ordinary income was taxed at a 40% rate. In this case the depreciation would offset ordinary income and provide tax savings of $240,000, but the $600,000 gain on the sale would be treated as a capital gain and produce a tax of only $120,000. Thus, even though the taxpayer has had no economic gain or loss with respect to the property—he bought and sold the equipment for $1,000,000—he was able to secure a tax benefit of $120,000 ($240,000 − $120,000).

The above example clearly illustrates how taxpayers used rapid depreciation and the favor-able treatment of § 1231 gains to effectively convert ordinary income into capital gain. In fact, this strategy—deferring taxes with quick depreciation write-offs at ordinary rates and giving them back later at capital gains rates—was the foundation of many tax shelter schemes.

Legislation to limit these benefits came in a number of forms, but the most important was the enactment of the so-called depreciation recapture rules. These rules strike right at the heart of the problem, generally treating all or some portion of any gain recognized as or-dinary income, based on the amount of depreciation previously deducted. Thus, in the above example, the taxpayer’s $600,000 gain, which was initially characterized as a § 1231 gain, is treated as ordinary income because of the $600,000 of depreciation previously claimed. In this way, all of the tax savings initially given away by virtue of the ordinary depreciation deductions are recaptured. In this regard, it may be useful to think of a gain as consisting of two parts: the gain attributable to depreciation and the gain attributable to holding the asset (resulting from appreciation and inflation). “Depreciation gains” normally are treated as ordinary income while “holding gains” are § 1231 gains and potentially taxed as long-term capital gains. Unfortunately, much like § 1231 in general, the recapture rules can become quite complex. The operations of the specific provisions are discussed below.

wHen aPPlicaBle

Before specific recapture rules are examined, there are two very important points to keep in mind. First, depreciable assets held for one year or less do not qualify for § 1231 treatment. Thus, any gain from the disposition of such assets is always reported as ordinary income. Second, the depreciation recapture rules do not apply if property is disposed of at a loss. Remember that losses from the sale or exchange of depreciable assets are treated as § 1231 losses if the property is held more than a year. In addition, casualty or theft losses of such property are included in the § 1231 netting process. Any loss from a depreciable asset held one year or less is an ordinary loss regardless of whether it was sold, exchanged, stolen, or destroyed.

tyPes of dePreciation recaPture

There are essentially three depreciation recapture provisions in the Code. These are:

1. Section 1245 Recapture—commonly called the full recapture rule, and applicable primarily to depreciable personalty (rather than realty)

LO.4Explain the purpose of the depreciation recapture rules.


2. Section 1250 Recapture—commonly called the partial recapture rule, and applicable to most depreciable realty if a method of depreciation other than straight-line was used

3. Section 291 Recapture—commonly called the additional recapture rule, and applicable only to corporate taxpayers

These depreciation recapture provisions affect the character—not the amount—of the gain. Losses are not affected. Each of these recapture rules is discussed below.

full recaPture—§ 1245The recapture concept was first introduced with the enactment of § 1245 by the Revenue Act of 1962. Section 1245 generally requires any gain recognized to be reported as ordinary income to the extent of any depreciation allowed on § 1245 property after 1961.

Definition of § 1245 PropertyThe recapture of depreciation under § 1245 applies only to § 1245 property, normally de-preciable personal property.19 Because the definition of personal property itself is so broad, § 1245 generally covers a wide variety of depreciable assets such as:

• Machinery and equipment used in production of goods and services

• Office furniture and equipment

• Automobiles, vans, trucks, and other transportation equipment

• Livestock used for breeding or production

• Intangibles such as patents, copyrights, trademarks, and goodwill that have been am-ortized under § 197 or otherwise.

Essentially the amortization is treated the same as depreciation, just like any portion of the cost of a depreciable asset that is expensed under § 179 is treated as depreciation al-lowed.20 It is important to understand that § 1245 applies only if the property is depreciable or amortizable. Consequently, it pertains only to property that is used in a trade or business and property held for the production of income. For example, livestock that are considered inventory are not subject to depreciation and are therefore not § 1245 property, although any gain or loss from the disposition of inventory is ordinary income.

Although the above definition is usually sufficient, § 1245 property actually includes a number of other assets besides depreciable personalty, including the following:21

1. Property used as an integral part of manufacturing, production, or extraction, or in furnishing transportation, communications, electrical energy, gas, water, or sewage disposal services.

a. However, any portion of a building or its structural components is not included.

b. A research facility or a facility for the bulk storage of commodities related to an activity listed above is included.

2. A single-purpose agricultural or horticultural structure (e.g., greenhouses).

3. A storage structure used in connection with the distribution of petroleum or any pri-mary product of petroleum (e.g., oil tank).

4. Any railroad grading or tunnel bore.

5. Certain other property that is subject to a special provision allowing current deductibility or rapid amortization (e.g., pollution control facilities and railroad rolling stock).

LO.5Compute depreciation recapture under § 1245.

19 § 1245(a)(3).20 See § 197(f)(7) for intangibles and § 1245(a)(3)(D) for

expensed property and certain other properties subject to unique expensing rules.

21 The definition parallels that of § 38 property, which qualified for the investment tax credit. § 48(a)(1).


Operation of § 1245Section 1245 generally requires any gain recognized to be treated as ordinary income to the extent of any depreciation allowed.22 To state the rule in another way: any gain on the disposition of § 1245 property is ordinary income to the extent of the lesser of the gain rec-ognized or the § 1245 recapture potential, generally the depreciation claimed and deducted. Although both statements say the same thing, the latter helps focus attention on two points and eliminates some misconceptions. First, a taxpayer is never required to report more income than the amount of gain realized regardless of the amount of depreciation claimed and deducted (i.e., regardless of the amount of recapture potential). For example, if the taxpayer realizes a gain of $10,000 and has deducted depreciation of $15,000, the taxpayer reports only $10,000 of income, all of which would be ordinary. Note that the depreciation recapture rules do not affect the amount of gain or loss, only the character of any gain to be recognized. Second, using the term recapture potential helps emphasize that sometimes the amount that must be recaptured may include more than mere depreciation.

Section 1245 recapture potential includes all depreciation or amortization allowed (or allowable) with respect to a given property—regardless of the method of depreciation used. This is why § 1245 is often called the full recapture rule. Recapture potential also includes adjustments to basis related to items that are expensed (e.g., under § 179 expense election) or where tax credits have been allowed under various sections of the Code.23

To summarize, determining the character of gain on the disposition of § 1245 property is generally a three-step process:

1. Determine the amount of gain to be recognized, if any.

2. The gain is ordinary income to the extent of the lesser of the gain recognized or the § 1245 recapture potential (all depreciation allowed or allowable).

3. Any recognized gain in excess of the recapture potential retains its original character, usu-ally § 1231 gain.

Recall that there is no § 1245 depreciation recapture when a property is sold at a loss, so any loss is normally a § 1231 loss.

Example 8

T owned a printing press that he used in his business. Its cost was $6,800 and T deducted depreciation in the amount of $3,200 during the three years he owned the press. T sold the press for $4,000 and his realized and recognized gain is $400 ($4,000 sales price − $3,600 adjusted basis). T’s recapture potential is $3,200, the amount of depreciation taken on the property. Thus, the entire $400 gain is ordinary income under § 1245.

Example 9

Assume the same facts as in Example 8, except that T sold his press for $7,000. In this case, T’s realized and recognized gain would be $3,400 ($7,000 − $3,600). The ordinary income portion under § 1245 would be $3,200 (the amount of the recapture potential), and the remaining $200 of the gain is a § 1231 gain. Note that in order for any § 1231 gain to occur, the property must be sold for more than its original cost since all of the depreciation is treated as ordinary income.

22 § 1245(a). 23 See § 1245(a)(2) for a listing of these adjustments and their related Code sections, including the basis adjustment related to the earned portion of any investment credit.


Example 10

Assume the same facts as in Example 8, except that the printing press is sold for $3,000 instead of $4,000. In this case, T has a loss from the sale of $600 ($3,000 − $3,600 adjusted basis). Because there is a loss, there is no depreciation recapture. All of T’s loss is a § 1231 loss.

Exceptions and LimitationsIn many ways, § 1245 operates much like the proverbial troll under the bridge. It sits ready to spring on its victim whenever the proper moment arises. Section 1245 generally applies whenever there is a transfer of property. However, § 1245 does identify certain situations where it does not apply, most of which are nontaxable events. For example, there is no re-capture on a transfer by gift or bequest since both of these are nontaxable transfers.24

In involuntary conversions and like-kind exchanges, the depreciation recapture under § 1245 is limited to the gain recognized.25 Similarly, in nontaxable business adjustments such as the formation of partnerships, transfers to controlled corporations, and certain cor-porate reorganizations, § 1245 recapture is limited to the gain recognized under the control-ling provisions.26 In any situation where recapture is not triggered, it is generally not lost but carried over in some fashion.

Partial recaPture—§ 1250As originally enacted in 1961, the concept of recapture as set forth in § 1245 generally ap-plied only to personalty. Gains derived from dealing in realty were not subject to recapture. In 1963, however, Congress eliminated this omission by enacting § 1250, a special recapture provision that applied to most buildings. Since 1963, § 1245 has generally been associated with depreciation recapture for personal property while § 1250 served that role for build-ings. Although the two provisions are similar, § 1250 is far less damaging. Specifically, § 1250 calls for the recapture of only a portion of any accelerated depreciation allowed with respect to § 1250 property. Note that while §§ 1250 and 1245 are essentially the same—they both convert potential capital gain into ordinary income—§ 1250 differs from § 1245 in several important ways: (1) it applies only if an accelerated method is used; (2) it does not require recapture of all the depreciation deducted but only a portion—generally only the excess of accelerated depreciation over what straight-line would have been; and (3) it applies to a different type of property, buildings and their components, rather than personal property. These basic concepts are illustrated in the following example and discussed fur-ther below.

Example 11

T purchased an office building in 1979 for $600,000. In 1979, depreciation gener-ally was computed using either the straight-line or accelerated method based on the estimated useful life of the property and estimated salvage value, all determined by the taxpayer. T depreciated the building over its estimated useful life of 40 years, using an accelerated method and no salvage value. This year, T sold the building for $900,000. At the time of sale, accelerated depreciation actually deducted was $500,000. Straight-line depreciation using the same facts would have been $300,000. The building is § 1250 property since it is realty acquired after 1969. As determined below, T recognizes a gain of $800,000, $200,000 is recaptured as ordinary income under § 1250 and the $600,000 balance is § 1231 gain.

24 §§ 1245(b)(1) and (2). Recapture of depreciation under § 1245 is required, however, to the extent § 691 applies (relating to income in respect to a decedent).25 § 1245(b)(4).

26 § 1245(b)(3). See Chapter 19 for further discussion of nontaxable business adjustments.

LO.6Compute depreciation recapture under § 1250.


Amount realized . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $900,000*Adjusted basis Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $600,000 Depreciation (accelerated) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (500,000)

Adjusted basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (100,000)

Gain on sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 800,000Depreciation recapture under § 1250 Accelerated depreciation actually deducted . . . . . . . . . . . . . . . . . . . . . . . . $500,000 Hypothetical straight-line depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . (300,000)

Section 1250 recapture reported as ordinary income . . . . . . . . . . . . . . . . . $ 200,000Section 1231 gain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 600,000

* A separate allocation and calculation would be required to determine any gain or loss on the land and is ignored here for simplicity.

Note that under the partial recapture rule of § 1250 only the excess of the actual amount of accelerated depreciation deducted ($500,000) over what the straight-line depreciation would have been ($300,000), a difference of $200,000, is recaptured. This excess is treated as ordinary income. Had the property been § 1245 property, all $500,000 would have been recaptured. Also observe that under § 1250 none of the straight-line depreciation, $300,000 is recaptured. However, this unrecaptured depre-ciation on § 1250 property is taxed at a maximum rate of 25% as discussed below.

As noted in the example, § 1250 does not recapture the straight-line depreciation. In enact-ing § 1250 Congress wanted to ensure that ordinary income treatment would be applied only to what were truly excess depreciation deductions. Gain not attributable to excess deprecia-tion was considered attributable to a rise in price levels and was eligible for relief provided for capital gains and not subject to recapture.

Section 1250 PropertySection 1250 property is generally any real property that is depreciable and is not covered by § 1245.27 For the most part, § 1250 applies to all of the common forms of real estate such as office buildings, warehouses, apartment complexes, and low-income housing. As a prac-tical matter, sales of these properties rarely produce recapture because the law has required the straight-line method for depreciation since 1986. However, Section 1250 property also includes 15- and 20-year realty which is depreciated using the 150 percent declining balance and, therefore, is capable of creating excess depreciation. This category includes such assets as multi-purpose agricultural structures (e.g., barns), land improvements (roads, sidewalks, fences, landscaping, shrubbery, docks), gas stations, convenience stores and more. As ex-plained earlier, nonresidential real estate (e.g., warehouses and office buildings) placed in service after 1980 and before 1987 for which an accelerated method was used is covered by the full recapture rule of § 1245.28

Depreciation of Real PropertySection 1250 applies only if an accelerated method of depreciation is used. If the straight-line depreciation method is used, § 1250 does not apply and there is no depreciation recapture for noncorporate taxpayers.29 For this reason, a critical first step in determining the relevance of § 1250 is determining how the taxpayer has depreciated the realty.

Realty Placed in Service before 1987. Prior to 1987, taxpayers could choose to use either an accelerated or straight-line method to compute depreciation for realty. This was an extremely important decision. It affected not only the amount of depreciation the taxpayer claimed but also the character of any gain on a subsequent disposition of the property. For example, a taxpayer could accelerate depreciation deductions but only at the possible expense

27 § 1250(c).28 It is important to note, however, that such properties are

§ 1250 property if the optional straight-line method is used. § 1245(a)(5).

29 As explained within, corporate taxpayers are still required to recapture 20 percent of any straight-line depreciation under § 291. Also, any unrecaptured straight-line depreciation is taxed at a maximum rate of 25 percent.


of recapture. Alternatively, the taxpayer could accept the slower-paced straight-line method and avoid the § 1250 recapture rules. But the Tax Reform Act of 1986 ended this flexibility and at the same time simplified the law. Taxpayers who place realty in service after 1986 must use the straight-line method for residential and nonresidential realty. As a result, the recap-ture rules of § 1250 do not apply to residential and nonresidential realty acquired after 1986. However, much of the existing inventory of real property was acquired before 1987 and may therefore be subject to § 1250, depending on the depreciation method used.

Realty Placed in Service from 1981 through 1986. For real property acquired between the beginning of 1981 and the end of 1986, the taxpayer could either use the accel-erated depreciation method allowed under ACRS or elect an optional straight-line method. In most cases, a taxpayer would select the accelerated method. If an accelerated method is used for residential realty acquired during 1981 through 1986, § 1250 applies, requiring recapture of the excess depreciation. However, as noted earlier, if an accelerated method is used for nonresidential realty acquired during 1981 through 1986, the property is consid-ered § 1245 and the full recapture rule applies.

By the close of 2005, realty acquired during 1981 through 1986 became fully depreci-ated since the lives were 15, 18 or 19 years during this time. As a result, there is no § 1250 recapture for residential realty since there is no excess depreciation (i.e., total accelerated de-preciation would be identical to total straight-line depreciation). Similarly, there is no § 1250 recapture for nonresidential realty if the straight-line method was used. However, to reiterate, if the accelerated method was used in depreciating nonresidential realty acquired during these tainted years, 1981–1986, § 1245 applies and all of the accelerated depreciation is recaptured.

Realty Placed in Service before 1981. All depreciable real property acquired before 1981 is classified as § 1250 property. For such property acquired before 1981 (non-ACRS property), taxpayers were required to estimate useful lives and salvage values. Although various methods could be used, there were restrictions.30 In those situations where an accelerated method was used, § 1250 applies subject to certain limitations. As discussed further below, none of the excess depreciation produced by realty for years after 1963 and before 1970 is subject to recapture. In the case of low-income housing and other residential real estate, excess depreciation resulting after 1969 and before 1976 is no longer recaptured. After 1975, excess depreciation on low-income housing is exempt from recapture if the property is held more than 16 2/3 years.

Summary of § 1250 ApplicationThe significance of § 1250 has declined considerably over the years. Subject to certain un-usual situations (e.g., certain low-income housing, certain Liberty Zone property, etc.), the following general observations can be made about the current status of § 1250:

• For residential and nonresidential realty acquired after 1986, there is no § 1250

• recapture because the straight-line method must be used for such property and no ex-cess depreciation results.

• For residential realty acquired during 1981–1986 there is no § 1250 recapture since these assets are fully depreciated and there is no excess depreciation.

• For nonresidential realty acquired during 1981–1986 for which the straight-line method was used, there is no recapture under § 1250, but § 1245 requires full-recapture if an accelerated method was used for the property.

• The reach of § 1250 is usually limited to realty acquired during 1970–1980. And much of this property, which at this point is 27–37 years old, has turned over and in the hands of the new buyer § 1250 does not apply.

Although the traditional recapture rules of § 1250 may not apply, gains on § 1250 property are not guaranteed the benefits of favorable capital gain rates. As explained further below, such gains may be taxed at a rate of up to 25 percent to the extent of any unrecaptured straight-line depreciation.

30 § 167(j).


Operation of § 1250The two critical factors in determining the amount, if any, of § 1250 recapture are the gain realized and the amount of excess depreciation. Excess depreciation refers to depreciation deductions in excess of that which would be deductible using the straight-line method. For property held one year or less, all depreciation is considered excess depreciation.31

As a general rule, § 1250 requires recapture of the excess depreciation, that is, the excess of accelerated over straight-line. Consequently, even if the taxpayer uses an acceler-ated method to compute the amount of depreciation deducted on the return, the hypothetical amount of straight-line depreciation must still be computed in order to determine the excess of accelerated over straight-line when the property is sold. In determining the hypothetical amount of straight-line depreciation, the taxpayer uses the same life and salvage value, if any, that were used in computing accelerated depreciation.32 Because of this approach, a taxpayer who uses the straight-line method would have no excess depreciation and no re-capture. Because the § 1250 recapture rule applies only to any excess depreciation claimed by a taxpayer, it is sometimes referred to as the partial recapture rule. However, it should be emphasized that beginning in 1997, the unrecaptured § 1250 depreciation (e.g., the straight-line depreciation) on § 1250 property held more than 12 months is subject to a special 25 percent tax rate (assuming it survives the § 1231 netting process).

Determining the taxation of any gain recognized on the disposition of § 1250 property is a four-step process:

1. Determine the amount of gain to be recognized, if any.

2. The gain is ordinary income to the extent of the lesser of the gain recognized or the § 1250 recapture potential (generally the excess depreciation allowed).33

3. Any recognized gain in excess of the recapture potential is usually treated as § 1231 gain.

4. Any gain recognized on § 1250 property held more than 12 months that is due to deprecia-tion that is not recaptured and which survives the applicable netting processes is taxed at a maximum rate of 25 percent to the extent of any unrecaptured depreciation. Any additional gain is generally 15 percent gain.

Two other considerations should be noted. If § 1250 property is held for a year or less, all depreciation (not just the excess) is recaptured.34 In addition, there is no § 1250 depreciation recapture when a property is sold at a loss, so any loss is normally a § 1231 loss.

Unrecaptured § 1250 GainAs may be apparent from step 3 above, under § 1250, taxpayers are required to recapture depreciation only if an accelerated method is used to depreciate the property. Consequently, individual taxpayers never recapture depreciation on § 1250 property if the method is used. Without some special rule, any gain attributable to straight-line depreciation for § 1250 property held more than 12 months would normally qualify for taxation at a 15 percent rate. Congress felt this treatment was too generous and created a special rule for unrecaptured § 1250 gain. The unrecaptured § 1250 gain is the lesser of (1) the gain recognized, or (2) the depreciation allowed after each (the gain recognized and the depreciation allowed) is reduced by any § 1250 recapture. The resulting amount will equal the amount of straight-line depreciation that was claimed or would have been claimed had the straight-line method been used (or, if less, the gain recognized minus the § 1250 recapture).

31 § 250(b).32 § 1250(b)(5).

33 See § 1250(a) and discussion following dealing with recapture of only a portion of the excess depreciation for certain properties.

34 § 1250(b)(1).


Example 12

About 10 years ago, F purchased some residential rental property for $100,000. This year he sold the property for $110,000. He had claimed straight-line depreciation of $30,000 over this time, resulting in a basis of $70,000 (do not attempt to ver-ify this amount). As a result, F recognized a gain of $40,000. Since the property is realty and a straight-line depreciation method was used there is no § 1250 re-capture. Consequently, the entire gain is a § 1231 gain. However, the § 1231 gain will be treated as a 25% gain to the extent of any straight-line depreciation claimed. Therefore, $30,000 of the gain is a 25% § 1231 gain while $10,000 is a 15% § 1231 gain (i.e., in the capital gain netting process these will be 15% and 25% long-term gains, respectively). If F had sold the property for $90,000, he would have had a gain of $20,000, all of which would have been a 25% gain (i.e., the lesser of the gain real-ized, $20,000, or the unrecaptured straight-line depreciation, $30,000).

Example 13

Same facts and $110,000 sales price from Example 12 above, except that F also has a $400 gain on the sale of K Corporation stock held 26 months. F is single and has taxable income, excluding these transactions, of $90,000. F’s tax would be computed as follows (using the 2013 tax rates for single taxpayers):

Regular tax on $90,000: Tax on $87,850 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $17,891 Tax on excess at 15% [($90,000 − $87,850 5 $2,150) 3 28%] . . . . . . . . . . . . . . . . . . . . . . . 602

$18,493Tax on 15% gains (15% 3 $10,400) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,560Tax on 25% gains (25% 3 $30,000) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,500

Total tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $27,553

Combined ResultsThe net gain from the disposition of § 1250 property can be treated as ordinary income subject to the regular tax rate, 15 percent capital gain, and/or 25 percent capital gain (and rarely 28 percent capital gain). Each step in the netting and tax calculation processes has been covered. Examples 14 through 17 and Comprehensive Example 19 illustrate how they work in combination.

Example 14

During the current year, L sold a small office building for $38,000. The building cost $22,000 in 1980, and she had deducted depreciation of $12,000 using an ac-celerated method ($10,000 was assigned to the land and was not depreciable). Straight-line depreciation would have been $10,600. L’s gain recognized on the sale is $28,000 ($38,000 amount realized − $10,000 adjusted basis). Of that amount, $1,400 ($12,000 − $10,600 5 $1,400 excess depreciation) is ordinary income under § 1250 and the remainder, $26,600, is § 1231 gain. Of the $26,600 § 1231 gain, the unrecap-tured depreciation of $10,600 ($12,000 − $1,400) is a 25% gain. The $16,000 excess of the amount realized over the original basis is 15% gain.


Example 15

M purchased a rental duplex during 1986 for $60,000 (not including any value as-signed to land). He deducted $60,000 depreciation using the 19-year realty ACRS tables. Depreciation using the straight-line recovery percentages for 19-year realty would have resulted in total depreciation of $60,000 (the duplex is fully depreciated under each method). This year on May 3 M sold the property for $87,000. His gain is reported as follows:

Sales price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 87,000Less: Adjusted basis Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $60,000 Depreciation allowed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (60,000) (-0-)

Gain to be recognized . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 87,000

Accelerated depreciation claimed and deducted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 60,000Straight-line depreciation (hypothetical) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (60,000)

Excess depreciation subject to recapture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ -0-

Character of gain: Ordinary income (partial recapture) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ -0- § 1231 gain subject to 25% rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000 § 1231 gain subject to 15% rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27,000

Total gain recognized . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 87,000

First, observe that the property is residential property (rather than nonresidential property) so it is subject to §1250 that requires recapture of the excess of accelerated depreciation over straight line. In this case, however, there is no excess depreciation since the rental property is fully depreciated. Thus, without a special rule, the gain not recaptured under § 1250 might be subject to the 15% capital gains rate. However, the depreciation that has not been recaptured, $60,000, is carved out and is considered a 25% § 1231 gain. Also observe that the $60,000 of 25% § 1231 gain is the amount of straight-line depreciation. The remaining gain (i.e., the amount above the original cost) of $27,000 is a 15% § 1231 gain.

Example 16

Assume the same facts as in Example 15, except that M elected to recover his basis in the duplex using the 19-year straight-line method. Consequently she still recognizes gain of $87,000 computed as follows:

Sales price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 87,000 Less: Adjusted basis

Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $60,000 Depreciation (straight-line) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (60,000)

(-0-)

Gain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(87,000)

None of the gain is subject to § 1250 recapture since M used straight-line depreciation (a requirement after 1986). However, the amount representing the unrecaptured de-preciation (i.e., the straight-line depreciation) of $60,000 is considered a 25% § 1231 gain and the $27,000 balance is considered a 15% § 1231 gain.


Example 17

Assume the same facts as in Example 15, except that the property is an office building rather than a duplex. In this case, because the property is nonresidential real property and the accelerated method was used, the asset is treated as § 1245 property rather than § 1250 property. Thus, M is subject to full rather than partial depreciation re-capture. All of the $60,000 depreciation is recaptured and treated as ordinary income. The balance of the gain, $27,000 is treated as a 15% § 1231 gain.

History of § 1250Over the years, § 1250 has been changed frequently, with a general trend toward an expanded scope. The rules explained above apply only to depreciation allowed on nonresidential prop-erty after 1969 and residential property (other than low-income housing) after 1975. Only a portion of any other excess depreciation on § 1250 property is included in the recapture potential. The following percentages are applied to the gain realized in the transaction or the excess depreciation taken during the particular period, whichever is less:

1. For all excess depreciation taken after 1963 and before 1970, 100 percent less 1 per-cent for each full month over 20 months the property is held.35 Any sales after 1979 would result in no recapture of pre-1970 excess depreciation since this percentage, when calculated, is zero.

2. For all excess depreciation taken after 1969 and before 1976, as follows:

a. In the case of low-income housing, 100 percent less 1 percent for each full month the property is held over 20 months.

b. In the case of other residential rental property (e.g., an apartment building) and property that has been rehabilitated [for purposes of § 167(k)], 100 percent less 1 percent for each full month the property is held over 100 months.36

All sales from this group of real property after August 1992 will have no recapture of excess depreciation claimed before 1976.

3. For excess depreciation taken after 1975 on low-income housing and property that has been rehabilitated [for purposes of § 167(k)], 100 percent less 1 percent for each full month the property is held over 100 months.37

In summary, 100 percent of the excess depreciation allowed with respect to § 1250 property after 1975 is subject to recapture unless it falls into one of the above categories. Any gain recognized to the extent of any unrecaptured depreciation will be considered 25% gain. The rules for the various categories are set forth in § 1250(a).

Exceptions and Limitations under § 1250Generally, the exceptions and limitations that apply under § 1245 also apply under § 1250. Thus, gifts, inheritances, and most nontaxable exchanges are allowed to occur without trig-gering recapture.38 This exception is extended to any property to the extent it qualifies as a principal residence and is subject to deferral of gain under § 1034 or nonrecognition of gain under § 121.39 In such nontaxable exchanges, the excess depreciation (that is not re-captured) taken prior to the nontaxable exchange on the property transferred carries over to the property received or purchased.40 Similarly, in the case of gifts and certain nontaxable transfers in which the property is transferred to a new owner with a carryover basis, the excess depreciation carries over to the new owner.41 In the case of inheritances in which basis to

35 § 1250(a)(3).36 § 1250(a)(2).37 § 1250(a)(1).

38 §§ 1250(d)(1) through (d)(4).39 § 1250(d)(7).40 Reg. §§ 1.1250-3(d)(5) and (h)(4).


the successor in interest is determined under § 1014, no carryover of excess depreciation occurs.42

Certain like-kind exchanges and involuntary conversions may result in the recogni-tion of gain solely because of § 1250 if insufficient § 1250 property is acquired. Since not all real property is depreciable, it is possible that the replacement property would not be § 1250 property and would still qualify for nonrecognition under the appropriate rules of §§ 1033 or 1034. In such situations, gain will be recognized to the extent the amount that would be recaptured exceeds the fair market value of the § 1250 property received (property purchased in the case of an involuntary conversion).43

Example 18

D completed a like-kind exchange in the current year in which he transferred an apartment complex (§ 1250 property) for rural farmland (not § 1250 property). The apartment had cost D $175,000 in 1980 and depreciation of $89,000 has been taken under the 200% declining-balance method. D would have deducted $62,000 under the straight-line method.

The farm land was worth $200,000 at the time of the exchange. There were no improvements on the farm property. D’s realized gain on the exchange is $114,000 ($200,000 amount realized − $86,000 adjusted basis in property given up). If there had been no § 1250 recapture, then D would have had no recognized gain. Because the property acquired was not § 1250 property, § 1250 supersedes (overrides) § 1031. D has a recognized gain of $27,000 [($89,000 − $62,000), the amount of excess de-preciation], which is all ordinary income under § 1250.

Exhibit 17.2 provides an overview of the handling of sales and exchanges of business property. Exhibit 17.3 provides a chart that may be useful in summarizing property transac-tions. Note that for purposes of this Exhibit 17.3, no distinction is made between 15%, 25% and 28% § 1231 gains and losses or 15%, 25% and 28% capital gains and losses. A compre-hensive example of sales and exchanges of trade or business property is presented below.

41 Reg. §§ 1.1250-3(a), (c), and (f).42 Reg. § 1.1250-3(b).

43 § 1250(d)(4)(C). A similar rule is provided for rollovers (deferral) of gains from low-income housing under § 1039 [see § 1250(d)(8)].

EXHIBIT 17.2 Stepwise Approach to Sales or Exchange of Trade or Business Property—An Overview

Step 1: Determine the amount of gain to be recognized, if any. There is no recapture in the case of losses.

Step 2: Calculate any depreciation recapture on the disposition of § 1245 property and § 1250 property sold or exchanged at a taxable gain during the year.

Step 3: For any remaining gain (after recapture) on depreciable property held for more than one year, add to other § 1231 gains and losses and complete the § 1231 netting process.

• The § 1231 gain must be broken down into the portions that qualify as 15%CG and 25%CG (and rarely 28%CG).

Step 4: Complete the netting process for capital assets, taking into consideration the net § 1231 gain, if any.

• The § 1231 gain is combined with other long-term capital gains and losses (with separate netting for 15%CG, 25%CG, and 28%CG. Then the long-term capital gain or loss is combined with the short-term capital gain or loss.


EXHIBIT 17.3 Summary of Property Transactions


Example 19

Ted and Carol Smith sold the following assets during the current year:

Description Holding Period Selling Price Adjusted BasisRecognized Gain (Loss)

Land and building (straight-line depreciation)

3 years $14,000 $9,000 $5,000

Cost, $13,000

Depreciation allowed, $4,000

Photocopier 14 months 2,600 2,000 600

Cost, $2,500

Depreciation allowed, $500

Business auto 2 years 1,800 1,920 (120)

Cost, $4,000

Depreciation allowed, $2,080

In determining the tax consequences of these sales, the Smiths must start with gains and losses from § 1231 transactions. The ultimate treatment of the gains, the character of the gain and any possible depreciation recapture must be considered.

• On the sale of the land and the building, there is no depreciation recapture for the building since straight-line depreciation was used. However, there is unre-captured depreciation of $4,000 which is accounted for as a 25% § 1231 gain. The balance of the gain on the land and building, $1,000, is a 15% § 1231 gain.

• On the sale of the photocopier, $500 of the § 1231 gain of $600 is recaptured under § 1245 and treated as ordinary income. The balance of the gain, $100, is a 15% § 1231 gain.

• On the sale of the automobile, there is no recapture since it is sold at a loss. The $120 loss is treated as a 15% § 1231 loss. This information is summarized below.

Section 1231 Gains and Losses


28% 25% 15%

Land and building . . . . . . . . . . . . . . . $4,000 $1,000

Photocopier . . . . . . . . . . . . . . . . . . . 100

Automobile . . . . . . . . . . . . . . . . . . . .

(120)

Capital gains from § 1231 . . . . . . . . $0 $4,000 $ 980

In this situation, the Smiths net the various groups, resulting in net gains in each of the groups as shown above. These amounts are then combined with the appropriate capital gain groups to determine the final treatment. Note that if the Smiths had un-recaptured § 1231 losses, they would first offset the 28% gains, then 25% gains, and finally 15% gains. The information is summarized in Exhibit 17.3.


Example 20

Assume that the Smiths, from the previous example, had the following capital asset transactions during the same year:

DescriptionHolding Period

Selling Price

Adjusted Basis

Description of Gain or (Loss)

100 shares XY Corp. 4 months $ 3,200 $4,200 $(1,000) STCL

100 shares GB Corp. 3 years 3,200 4,600 (1,400) LTCL

1 acre vacant land 5 years 12,000 5,000 7,000 LTCG

Taking into consideration the § 1231 gains from Example 19, the Smith’s summarize their transactions as follows.

Short-Term Capital Gains and Losses


Ordinary 28% 25% 15%

Capital gains from § 1231 . . . . $0 $4,000 $ 980

XY stock loss . . . . . . . . . . . . . . . (1,000)

GB stock loss . . . . . . . . . . . . . . (1,400)

Vacant land gain . . . . . . . . . . . .

7,000

$(1,000) $0 $4,000 $6,580

Netting . . . . . . . . . . . . . . . . . . . 1,000

(1,000)

Total . . . . . . . . . . . . . . . . . . . . $ 0

$0

$3,000

$6,580

Ted and Carol Smith would report a $3,000 N25CG and a $6,580 N15CG.

A Form 4797, Schedule D and Schedule D Tax Worksheet containing the information from Examples 19 and 20 are included in Exhibit 17.4 that follows. Note that neither the Form 4797 nor Schedule D Parts I or II require the taxpayer to distinguish the 25% gains from the 28% or 15% gains. These distinctions come into view on Schedule D, Part III Summary where Line 18 refers to the 28% Rate Gain Worksheet and Line 19 requires iden-tification of the amount of unrecaptured § 1250 Gain Worksheet (i.e., the 25% gain). The actual tax is computed on the Schedule D Tax Worksheet that can be found in the instruc-tions for Form 1040 for Schedule D. On the Schedule D Tax Worksheet, the rates are more apparent (line 24 - 15%, line 30 - 25%, and line 33 - 28%). The tax for the taxpayers in Examples 19 and 20 is computed on the Schedule D Tax Worksheet, assuming the taxpayers have taxable income of $126,830 as computed below. Note that the taxable income includes the capital gains and recapture.

Wages . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $136,250Section 1245 recapture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500Capital gains N15CG . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $6,580 N25CG . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000 9,580

Adjusted gross income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $146,330Standard deduction for 2012 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (11,900)Exemptions for 2012 (2 3 $3,800) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ( 7,600)

Taxable income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $126,830

Tax per Schedule D Tax Worksheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 23,110


EXHIBIT 17.4 Completed Form 4797

OMB No. 1545-0184Sales of Business PropertyForm 4797(Also Involuntary Conversions and Recapture Amounts

Under Sections 179 and 280F(b)(2)) 2012G Attach to your tax return.Department of the Treasury Attachment

Internal Revenue Service Sequence No. 27G Information about Form 4797 and its separate instructions is atwww.irs.gov/form4797.Name(s) shown on return Identifying number

Enter the gross proceeds from sales or exchanges reported to you for 2012 on Form(s) 1099-B or 1099-S1(or substitute statement) that you are including on line 2, 10, or 20 (see instructions) 1

Part I Sales or Exchanges of Property Used in a Trade or Business and Involuntary Conversions From Other Than Casualty or Theft ' Most Property Held More Than 1 Year (see instructions)

(e) Depreciation (f) Cost or other2 (g) Gain or (loss)allowed or basis, plus(a) Description (b) Date acquired (c) Date sold (d) Grossallowable since improvements and Subtract (f) from theof property (month, day, year) (month, day, year) sales price acquisition expense of sale sum of (d) and (e)

3 3Gain, if any, from Form 4684, line 394 4Section 1231 gain from installment sales from Form 6252, line 26 or 375 5Section 1231 gain or (loss) from like-kind exchanges from Form 88246 6Gain, if any, from line 32, from other than casualty or theft

77 Combine lines 2 through 6. Enter the gain or (loss) here and on the appropriate line as follows:

Partnerships (except electing large partnerships) and S corporations. Report the gain or (loss) following theinstructions for Form 1065, Schedule K, line 10, or Form 1120S, Schedule K, line 9. Skip lines 8, 9, 11, and12 below.

Individuals, partners, S corporation shareholders, and all others. If line 7 is zero or a loss, enter the amount fromline 7 on line 11 below and skip lines 8 and 9. If line 7 is a gain and you did not have any prior year section 1231losses, or they were recaptured in an earlier year, enter the gain from line 7 as a long-term capital gain on theSchedule D filed with your return and skip lines 8, 9, 11, and 12 below.

8 8Nonrecaptured net section 1231 losses from prior years (see instructions)

Subtract line 8 from line 7. If zero or less, enter -0-. If line 9 is zero, enter the gain from line 7 on line 12 below. If9line 9 is more than zero, enter the amount from line 8 on line 12 below and enter the gain from line 9 as along-term capital gain on the Schedule D filed with your return (see instructions) 9

(see instructions)Part II Ordinary Gains and Losses Ordinary gains and losses not included on lines 11 through 16 (include property held 1 year or less):10

11 11Loss, if any, from line 712 12Gain, if any, from line 7 or amount from line 8, if applicable

1313 Gain, if any, from line 3114 14Net gain or (loss) from Form 4684, lines 31 and 38a15 15Ordinary gain from installment sales from Form 6252, line 25 or 3616 16Ordinary gain or (loss) from like-kind exchanges from Form 882417 17Combine lines 10 through 16

For all except individual returns, enter the amount from line 17 on the appropriate line of your return and skip lines18a and b below. For individual returns, complete lines a and b below:If the loss on line 11 includes a loss from Form 4684, line 35, column (b)(ii), enter that part of the loss here. Enterathe part of the loss from income-producing property on Schedule A (Form 1040), line 28, and the part of the lossfrom property used as an employee on Schedule A (Form 1040), line 23. Identify as from ʼForm 4797, line 18a.ʼ

18 aSee instructions

Redetermine the gain or (loss) on line 17 excluding the loss, if any, on line 18a. Enter here and on Form 1040,b18 bline 14

BAA For Paperwork Reduction Act Notice, see separate instructions. Form 4797 (2012)

Ted & Carol Smith 123-45-6789

5,100.4,980.

500.

500.

500.

Auto 03/01/09 10/02/12 1,800. 2,080. 4,000. -120.


EXHIBIT 17.4 Completed Form 4797— Continued

Form 4797 (2012) Page 2Part III Gain From Disposition of Property Under Sections 1245, 1250, 1252, 1254, and 1255

(see instructions)

(b) Date acquired (c) Date sold19 (a) Description of section 1245, 1250, 1252, 1254, or 1255 property: (mo, day, yr) (mo, day, yr)ABCD

These columns relate to the properties on linesProperty A Property B Property C Property D19A through 19D G

20 Gross sales price (Note: See line 120before completing.)

Cost or other basis plus expense of sale21 21Depreciation (or depletion) allowed or allowable22 22Adjusted basis. Subtract line 22 from line 2123 23Total gain. Subtract line 23 from line 2024 24

25 If section 1245 property:a 25aDepreciation allowed or allowable from line 22

Enter the smaller of line 24 or 25ab 25bIf section 1250 property: If straight26line depreciation was used, enter -0-on line 26g, except for a corporationsubject to section 291.

a 26aAdditional depreciation after 1975 (see instrs)b Applicable percentage multiplied by the smaller

26bof line 24 or line 26a (see instructions)

Subtract line 26a from line 24. If residential rentalcpropertyor line 24 is not more than line 26a, skip

26clines 26d and 26eAdditional depreciation after 1969 & before 1976d 26d

e Enter the smaller of line 26c or 26d 26eSection 291 amount (corporations only)f 26fAdd lines 26b, 26e, and 26fg 26gIf section 1252 property: Skip this section if you27did not dispose of farmland or if this form isbeing completed for a partnership (other thananelecting large partnership).

a Soil, water, and land clearing expenses 27aLine 27a multiplied by applicablebpercentage (see instructions) 27b

c Enter the smaller of line 24 or 27b 27c28 If section 1254 property:

a Intangible drilling and development costs,expenditures for development of mines and othernatural deposits, mining exploration costs, and

28adepletion (see instructions)b Enter the smaller of line 24 or 28a 28b

29 If section 1255 property:Applicable percentage of paymentsaexcluded from income undersection 126 (see instructions) 29a

b Enter the smaller of line 24 or 29a (see instrs) 29bComplete property columns A through D through line 29b before going to line 30.Summary of Part III Gains.

30 30Total gains for all properties. Add property columns A through D, line 2431 31Add property columns A through D, lines 25b, 26g, 27c, 28b, and 29b. Enter here and on line 13

Subtract line 31 from line 30. Enter the portion from casualty or theft on Form 4684, line 33. Enter the32portion from other than casualty or theft on Form 4797, line 6 32

Part IV Recapture Amounts Under Sections 179 and 280F(b)(2) When Business Use Drops to 50% or Less(see instructions)

(b) Section (a) Section 179 280F(b)(2)Section 179 expense deduction or depreciation allowable in prior years33 33

34 34Recomputed depreciation (see instructions)Recapture amount. Subtract line 34 from line 33. See the instructions for where to report35 35

FDIZ1002 09/13/12 Form 4797 (2012)BAA


5,600.500.

5,100.

07/14/0206/12/03

11/21/1208/31/12

14,000. 2,600.13,000. 2,500.4,000. 500.9,000. 2,000.5,000. 600.

500.500.

0.

0.

5,000.

0.

Land and buildingPhotocopier


EXHIBIT 17.5 Completed Schedule D

OMB No. 1545-0074SCHEDULE DCapital Gains and Losses(Form 1040)

G Attach to Form 1040 or Form 1040NR. 2012G Information about Schedule D and its separate instructions is at www.irs.gov/form1040.

Department of the Treasury AttachmentG Use Form 8949 to list your transactions for lines 1, 2, 3, 8, 9, and 10.(99)Internal Revenue Service 12Sequence No.Name(s) shown on return Your social security number

Part I Short-Term Capital Gains and Losses ' Assets Held One Year or Less(d) Proceeds (sales (e) Cost or other basisComplete Form 8949 before completing line 1, 2, (g) Adjustments to (h) Gain or (loss)

from Form(s) 8949, price) from Form(s) Subtract column (e) from or 3. This form may be easier to complete if you gain or loss from8949, Part I, line 2, Part I, line 2, column (d) and combine round off cents to whole dollars. Form(s) 8949, Part I,

column (d) column (e) the result with column (g)line 2, column (g)

Short-term totals from all Forms 8949 with1box A checked in Part I

Short-term totals from all Forms 8949 with2box B checked in Part I

Short-term totals from all Forms 8949 with3box C checked in Part I

4 4Short-term gain from Form 6252 and short-term gain or (loss) from Forms 4684, 6781, and 8824

5 5Net short-term gain or (loss) from partnerships, S corporations, estates, and trusts from Schedule(s) K-1

Short-term capital loss carryover. Enter the amount, if any, from line 8 of your Capital Loss Carryover6Worksheet in the instructions 6

Net short-term capital gain or (loss). Combine lines 1 through 6 in column (h). If you have any long-term77capital gain or losses, go to Part II below. Otherwise, go to Part III on page 2

Part II Long-Term Capital Gains and Losses ' Assets Held More Than One Year(d) Proceeds (sales (e) Cost or other basisComplete Form 8949 before completing line 8, 9, (g) Adjustments to (h) Gain or (loss)

from Form(s) 8949, price) from Form(s) Subtract column (e) from or 10. This form may be easier to complete if you gain or loss from8949, Part II, line 4, Part II, line 4, column (d) and combine round off cents to whole dollars. Form(s) 8949, Part II,

column (d) column (e) the result with column (g)line 4, column (g)

Long-term totals from all Forms 8949 with8box A checked in Part II

Long-term totals from all Forms 8949 with9box B checked in Part II

Long-term totals from all Forms 8949 with10box C checked in Part II

Gain from Form 4797, Part I; long-term gain from Forms 2439 and 6252; and long-term gain or (loss) from1111Forms 4684, 6781, and 8824

12 12Net long-term gain or (loss) from partnerships, S corporations, estates, and trusts from Schedule(s) K-1

13Capital gain distributions. See instrs13Long-term capital loss carryover. Enter the amount, if any, from line 13 of your Capital Loss Carryover14Worksheet in the instructions 14

Net long-term capital gain or (loss). Combine lines 8 through 14 in column (h). Then go to Part III on1515page 2

Schedule D (Form 1040) 2012BAA For Paperwork Reduction Act Notice, see your tax return instructions.


3,200. 4,200. -1,000.

-1,000.

15,200. 9,600. 5,600.

4,980.

10,580.


EXHIBIT 17.5 Completed Schedule D—Continued

Schedule D (Form 1040) 2012 Page 2

Part III Summary

16 16Combine lines 7 and 15 and enter the result

? If line 16 is a gain, enter the amount from line 16 on Form 1040, line 13, or Form 1040NR, line 14. Then go to line 17 below.If line 16 is a loss, skip lines 17 through 20 below. Then go to line 21. Also be sure to complete line 22.?

? If line 16 is zero, skip lines 17 through 21 below and enter -0- on Form 1040, line 13, or Form 1040NR, line 14. Then to go line 22.

17 Are lines 15 and 16 both gains?

Yes. Go to line 18.

No. Skip lines 18 through 21, and go to line 22.

Enter the amount, if any, from line 7 of the 28% Rate Gain Worksheet in the instructions18 18G

Enter the amount, if any, from line 18 of the Unrecaptured Section 1250 Gain Worksheet in1919the instructions G

20 Are lines 18 and 19 both zero or blank?

Yes. Complete the Qualified Dividends and Capital Gain Tax Worksheet in the instructions for Form 1040, line 44 (or in the instructions for Form 1040NR, line 42). Do not complete lines21 and 22 below.

No. Complete the Schedule D Tax Worksheet in the instructions. Do not complete lines 21 and 22 below.

21 If line 16 is a loss, enter here and on Form 1040, line 13, or Form 1040NR, line 14, the smaller of:

? The loss on line 16 or 21? ($3,000), or if married filing separately, ($1,500)

Note. When figuring which amount is smaller, treat both amounts as positive numbers.

22 Do you have qualified dividends on Form 1040, line 9b, or Form 1040NR, line 10b?

Yes. Complete the Qualified Dividends and Capital Gain Tax Worksheet in the instructions for Form 1040, line 44 (or in the instructions for Form 1040NR, line 42).

No. Complete the rest of Form 1040 or Form 1040NR.

Schedule D (Form 1040) 2012


9,580.

X

3,000.

X


OMB No. 1545-0074Form 8949 Sales and Other Dispositions of Capital Assets 2012G Information about Form 8949 and its separate instructions is at www.irs.gov/form8949.Department of the Treasury AttachmentInternal Revenue Service 12AG File with your Schedule D to list your transactions for lines 1, 2, 3, 8, 9, and 10 of Schedule D. Sequence No.Name(s) shown on return SSN or taxpayer identification no.

Most brokers issue their own substitute statement instead of using Form 1099-B. They also may provide basis information (usually your cost) to you on the statement even if it is not reported to the IRS. Before you check Box A, B, or C below, determine whether you received any statement(s) and, if so, the transactions for which basis was reported to the IRS. Brokers are required to report basis to the IRS for most stock you bought in 2011 or later.

Short-Term. Transactions involving capital assets you held one year or less are short term. For long-Part Iterm transactions, see page 2.

You must check Box A, B, or C below. Check only one box. If more than one box applies for your short-term transactions, complete a separateForm 8949, page 1, for each applicable box. If you have more short-term transactions than will fit on this page for one or more of the boxes, complete as many forms with the same box checked as you need.

(A) Short-term transactions reported on Form(s) 1099-B showing basis was reported to the IRS(B) Short-term transactions reported on Form(s) 1099-B showing basis was not reported to the IRS(C) Short-term transactions not reported to you on Form 1099-B

Adjustment, if any, to gain or loss. (h)1 (a) (b) (e)(c) If you enter an amount in column (g), (d) Gain or (loss).enter a code in column (f). Date acquired Cost or other basis. Date sold or ProceedsDescription of property Subtract column See the separate instructions.(Example: 100 shares XYZ Co) disposed(Mo, day, yr) See the Note below (sales price) (e) from column (Mo, day, yr) and see Column (e)(see instructions) (d) and combine (f) (g)in the separate Code(s) from Amount of the result with instructionsinstructions adjustment column (g)

Totals. Add the amounts in columns (d), (e), (g), and (h) 2(subtract negative amounts). Enter each total here and include on your Schedule D, line 1 (if Box A above is checked), line 2 (if Box B above is checked), or line 3 (ifBox C above is checked) G

Note. If you checked Box A above but the basis reported to the IRS was incorrect, enter in column (e) the basis as reported to the IRS, and enteran adjustment in column (g) to correct the basis. See Column (g) in the separate instructions for how to figure the amount of the adjustment.

FDIA9212 12/31/12BAA For Paperwork Reduction Act Notice, see your tax return instructions. Form 8949 (2012)


X

3,200. 4,200. -1,000.

100.0000 sh. XY Corp. 08/01/12 12/01/12 3,200. 4,200. -1,000.


Attachment Sequence No. Form 8949 (2012) 12A Page 2Name(s) shown on return. (Name and SSN or taxpayer identification no. not required if shown on other side.) SSN or taxpayer identification no.

Most brokers issue their own substitute statement instead of using Form 1099-B. They also may provide basis information (usually your cost) to you on the statement even if it is not reported to the IRS. Before you check Box A, B, or C below, determine whether you received any statement(s) and, if so, the transactions for which basis was reported to the IRS. Brokers are required to report basis to the IRS for most stock you bought in 2011 or later.

Long-Term. Transactions involving capital assets you held more than one year are long term. For Part IIshort-term transactions, see page 1.

You must check Box A, B, or C below. Check only one box. If more than one box applies for your long-term transactions, complete a separateForm 8949, page 2, for each applicable box. If you have more long-term transactions than will fit on this page for one or more of the boxes, complete as many forms with the same box checked as you need.

(A) Long-term transactions reported on Form(s) 1099-B showing basis was reported to the IRS(B) Long-term transactions reported on Form(s) 1099-B showing basis was not reported to the IRS(C) Long-term transactions not reported to you on Form 1099-B

Adjustment, if any, to gain or loss. (h)3 (a) (b) (e)(c) If you enter an amount in column (g), (d) Gain or (loss).enter a code in column (f). Date acquired Cost or other basis. Date sold or ProceedsDescription of property Subtract column See the separate instructions.(Example: 100 shares XYZ Co) disposed(Mo, day, yr) See the Note below (sales price) (e) from column (Mo, day, yr) and see Column (e)(see instructions) (f) (g) (d) and combine in the separate Code(s) from Amount of the result with instructionsinstructions adjustment column (g)

Totals. Add the amounts in columns (d), (e), (g), and (h) 4(subtract negative amounts). Enter each total here and include on your Schedule D, line 8 (if Box A above ischecked), line 9 (if Box B above is checked), or line 10 (ifBox C above is checked)

Note. If you checked Box A above but the basis reported to the IRS was incorrect, enter in column (e) the basis as reported to the IRS, andenter an adjustment in column (g) to correct the basis. See Column (g) in the separate instructions for how to figure the amount of the adjustment.

FDIA9212 12/31/12 Form 8949 (2012)


X

15,200. 9,600. 5,600.

100.0000 sh. GB Corp.

Vacant Land

12/01/09

12/01/07

12/01/12

12/01/12

3,200.

12,000.

4,600.

5,000.

-1,400.

7,000.


EXHIBIT 17.5 Completed Schedule D—Continued

Form 1040 Schedule D Tax Worksheet 2012Line 44 G Keep for your records

Name(s) Shown on Return Social Security Number

1 a Enter your taxable income from Form 1040, line 43 1 ab Enter the amount from your (and your spouseʼs) Form 2555, line 45 bc Add lines 1a and 1b 1 c

2 a Enter your qualified dividends from Form 1040, line 9b 2 a

b Enter any capital gain excess attributable to qualified dividends b

c Subtract line 2b from line 2a 2 c3 Amount from Form 4952, line 4g 34 a Amount from Form 4952, line 4e 4 a

b Amount from the dotted line next to Form 4952, line 4e b

c Line 4b, if applicable, 4a, if not c5 Subtract line 4c from line 3. 56 Subtract line 5 from line 2c. If zero or less, enter -0- 67 a Enter line 15 of Schedule D 7 a

b Enter line 16 of Schedule D bc Enter the smaller of line 7a or line 7b 7 c

8 Enter the smaller of line 3 or line 4c 89 a Subtract line 8 from line 7. 9 a

b Enter any capital gain excess attributable to capital gains b

c Subtract line 9b from line 9a 9 c10 Add lines 6 and 9c 1011 a Enter the amount from Schedule D, line 18 11 a

b Enter the amount from Schedule D, line 19 bc Add lines 11a and 11b 11 c

12 Enter the smaller of line 9c or line 11c 1213 Subtract line 12 from line 10 1314 Subtract line 13 from line 1c. If zero or less, enter -0- 1415 Enter:

? $35,350 if single or married filing separately;? $70,700 if married filing jointly or qualifying widow(er); or 15? $47,350 if head of household.

16 Enter the smaller of line 1c or line 15 1617 Enter the smaller of line 14 or line 16 1718 Subtr ln 10 from ln 1c. If zero or less, enter -0- 1819 Enter the larger of line 17 or line 18 1920 Subtract line 17 from line 16. This amount is taxed at 0% 20

If lines 1c and 16 are the same, skip lines 21 through 33and go to line 34. Otherwise, go to line 21.

21 Enter the smaller of line 1c or line 13 2122 Enter the amount from line 20 (if line 20 is blank, enter -0-) 2223 Subtract line 22 from line 21. If zero or less, enter -0- 2324 Multiply line 23 by 15% (.15) 24

If Schedule D, line 19, is zero or blank, skip lines 25 through 30and go to line 31. Otherwise, go to line 25.

25 Enter the smaller of line 9c above or Schedule D, line 19 2526 Add lines 10 and 19 2627 Enter the amount from line 1c above 2728 Subtract line 27 from line 26. If zero or less, enter -0- 2829 Subtract line 28 from line 25. If zero or less, enter -0- 2930 Multiply line 29 by 25% (.25) 30

If Schedule D, line 18, is zero or blank, skip lines 31 through 33and go to line 34. Otherwise, go to line 31.

31 Add lines 19, 20, 23, and 29 3132 Subtract line 31 from line 1c 3233 Multiply line 32 by 28% (.28) 3334 Figure the tax on the amount on line 19. If the amount on line 19 is less than $100,000,

use the Tax Table to figure this tax. If the amount on line 19 is $100,000 or more,use the Tax Computation Worksheet 34

35 Add lines 24, 30, 33, and 34 3536 Figure the tax on the amount on line 1c. If the amount on line 1c is less than $100,000,

use the Tax Table to figure this tax. If the amount on line 1c is $100,000 or more,use the Tax Computation Worksheet 36

37 Tax on all taxable income (including capital gains and qualified dividends).Enter the smaller of line 35 or line 36. Also include this amount on Form 1040, line 44 37


126,830.

126,830.

0.0.

10,580.9,580.

9,580.

9,580.

9,580.9,580.

0.3,000.

3,000.3,000.

6,580.120,250.

70,700.

70,700.70,700.

117,250.117,250.

0.

6,580.0.

6,580.987.

3,000.126,830.126,830.

0.3,000.

750.

21,373.23,110.

23,768.

23,110.


additional recaPture—corPorations

Corporations generally compute the amount of § 1245 and § 1250 ordinary income re-capture on the sales of depreciable assets in the same manner as do individuals. However, Congress added Code § 291 to the tax law in 1982 with the intent of reducing the tax bene-fits of the accelerated cost recovery of depreciable § 1250 property available to corporate taxpayers. For sales or other taxable dispositions of § 1250 property, corporations must treat as ordinary income 20 percent of any § 1231 gain that would have been ordinary income if § 1245 rather than § 1250 had applied to the transaction.44 The effect of this provision is to require the taxpayer to recapture 20 percent of any straight-line depreciation that has not been recaptured under some other provision. Technically, the amount that is treated as ordinary income under § 291 is computed in the following manner:

Amount that would be treated as ordinary income under § 1245 . . . . . . . . . . . . . . . . . $xx,xxx Less: Amount that would be treated as ordinary income § 1250 . . . . . . . . . . . . . . . (x,xxx)

Equals: Difference between recapture amounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $xx,xxx Times: Rate specified in § 291 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 320%

Equals: Amount that is treated as ordinary income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $xx,xxx

Example 21

This year K Corporation sold residential rental property for $500,000. The property was purchased for $400,000 in 1986. Assume that K claimed ACRS depreciation of $140,000 (i.e., do not attempt to verify this estimate). Straight-line depreciation would have been $105,000. K’s depreciation recapture and § 1231 gain are computed as follows:

Step 1: Compute realized gain: Sales price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $500,000 Less: Adjusted basis Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $400,000 ACRS depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (140,000) (260,000)

Realized gain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $240,000

Step 2: Compute excess depreciation: Actual depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $140,000 Straight-line depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (105,000)

Excess depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 35,000

Step 3: Compute § 1250 depreciation recapture: Lesser of: the realized gain of $240,000 or excess depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 35,000 § 1250 depreciation recapture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 35,000

Step 4: Compute depreciation recapture if § 1245 applied: Lesser of: the realized gain of $240,000 or actual depreciation $140,000 Depreciation recapture if § 1245 applied . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $140,000

LO.7Explain the additionalrecapture ruleapplicable only tocorporate taxpayers.

44 § 291(a)(1).


Step 5: Compute § 291 ordinary income: Depreciation recapture if § 1245 applied . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $140,000 § 1250 depreciation recapture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (35,000)

Excess recapture potential . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $105,000 Times: § 291 rate 3 20%

§ 291 ordinary income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 21,000

Step 6: Characterize recognized gain: § 1250 depreciation recapture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 35,000 Plus: § 291 ordinary income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,000

Ordinary income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 56,000

Realized gain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $240,000 Less: Ordinary income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (56,000)

§ 1231 gain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $184,000

Note that without the additional recapture required under § 291, K Corporation would have reported a § 1231 gain of $205,000 ($240,000 total gain − $35,000 § 1250 recap-ture). If the property had been subject to § 1245 recapture, K Corporation would have only a $100,000 § 1231 gain ($240,000 − $140,000 § 1245 recapture). Section 291 requires that the corporation report 20% of this difference ($205,000 − $100,000 5 $105,000 3 20%), or $21,000, as additional recapture. Note that this is 20% of the straight-line depreciation that is normally not recaptured on the disposition of non-residential or residential real estate.

Example 22

Assume the same facts as in Example 21, except that the property is an office build-ing rather than residential realty and straight-line depreciation was elected. An individual taxpayer would report the entire gain of $205,000 [$500,000 − ($400,000 basis − $105,000 straight-line depreciation)] as a § 1231 gain. However, the corporate taxpayer must recapture $21,000 (20% 3 $105,000 depreciation) as ordinary income under § 291. The remaining $184,000 ($205,000 − $21,000) would be a § 1231 gain.

otHer recaPture Provisions

There are several other recapture provisions that exist. They include the recapture of farm-land expenditures,45 recapture of intangible drilling costs,46 and recapture of gain from the disposition of § 126 property (relating to government cost-sharing program payments for conservation purposes).47 Another type of recapture is investment credit recapture.48 This is discussed in detail in Chapter 13.

cHeck your knowledge

Review Question 1True-False. This year T sold equipment for $6,000 (cost $15,000, depreciation $10,000), recognizing a gain of $1,000 ($6,000 − $5,000). To ensure that all of the ordinary deductions

45 § 1252.46 § 1254.

47 § 1255.48 § 47.


obtained from depreciation are recaptured, T must report ordinary income of $10,000 and a capital loss of $9,000, ultimately producing net income of $1,000.

False. This novel approach may seem consistent with Congressional intent, but it is incor-rect. Under § 1245 any gain realized is treated as ordinary income to the extent of any depreciation allowed. As a result, the entire $1,000 is ordinary income. It may be use-ful to think of the depreciation recapture as an adjustment to the depreciation claimed. Depreciation of $10,000 was claimed, but the value of the equipment dropped by $9,000 ($15,000 cost − $6,000 sales price). T claimed an ordinary depreciation deduction of $10,000, and recognized ordinary income of $1,000, for a net ordinary deduction of $9,000.

Review Question 2True-False. This year L sold a machine and recognized a small gain. Assuming L claimed straight-line depreciation, there is no depreciation recapture.

False. The machine is § 1245 property since it is depreciable personalty. Under the full re-capture rule of § 1245, all depreciation is subject to recapture regardless of the method used.

Review Question 3Several years ago Harry purchased equipment at a cost of $10,000. Over the past three years he claimed and deducted depreciation of $6,000. Assuming that Harry sold the equipment for (1) $7,000, (2) $13,000, or (3) $1,000, determine the amount of gain or loss realized and its character (i.e., ordinary income or § 1231 potential capital gain).

1 2 3

Amount realized . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 7,000 $13,000 $ 1,000

Adjusted basis ($10,000 − $6,000) . . . . . . . . . . . . . . −4,000

−4,000

− 4,000

Gain (loss) recognized . . . . . . . . . . . . . . . . . . . . . . . . $ 3,000

$ 9,000

$(3,000)

The equipment is § 1245 property since it is depreciable personalty. As a result, the full recapture rule operates and any gain recognized is ordinary income to the extent of any de-preciation deducted. In the first case, the entire $3,000 is ordinary income (the lesser of the gain recognized, $3,000, or the recapture potential, $6,000). In the second situation, $6,000 is ordinary income (the lesser of the gain recognized, $9,000, or the recapture potential, $6,000) and $3,000 is § 1231 gain. In the final case, § 1245 does not apply because the property is sold at a loss. Therefore, Harry has a § 1231 loss that is potentially an ordinary loss. Its ultimate treatment depends on the outcome of the § 1231 netting process.

Review Question 4True-False. In 1990, Sal purchased an office building to rent out. This year she sold the building, recognizing a large gain. The entire gain is a § 1231 gain since there is no recap-ture under either § 1245 or § 1250.

True. The office build is § 1250 property. The recapture rules of § 1250 apply only when the taxpayer uses an accelerated method, in which case the excess of accelerated depreciation over straight-line is treated as ordinary income. However, since 1987 taxpayers have been required to use the straight-line method in computing depreciation on real estate. As a re-sult, § 1250 is inapplicable and Sal’s gain retains its original § 1231 character. Nevertheless, the gain will not be treated as a 15 percent gain to the extent of any unrecaptured § 1250 depreciation (i.e., all of the straight-line depreciation) but rather 25 percent gain.

Review Question 5True-False. In 1997, Z Corporation purchased an office building to rent out. This year the corporation sold the building, recognizing a large gain. The entire gain is a § 1231 gain since there is no recapture under either § 1245 or § 1250.


False. There is no recapture under § 1245 or § 1250. However, under § 291, corporate tax-payers are required to recapture up to 20 percent of any straight-line depreciation. The 25 percent rate does not apply to corporate taxpayers.

Review Question 6True-False. In 1986, the Rose Partnership purchased a new office building to use as its headquarters. This year the partnership sold the building, recognizing a gain of $100,000. The partnership claimed and deducted accelerated depreciation of $40,000. Straight-line depreciation would have been $40,000. The partnership will report ordinary income of zero and § 1231 gain of $100,000.

False. This would be true if the building were § 1250 property, but § 1250 does not ap-ply. Nonresidential real estate such as this office building that was acquired from 1981 through 1986 is treated as § 1245 property and is subject to the full recapture rule if acceler-ated depreciation was used. In this case, the taxpayer opted for accelerated depreciation, so $40,000 is ordinary income and the remaining $60,000 is a 15% § 1231 gain.

Review Question 7True-False. In 1984, the Daisy Partnership purchased a new apartment complex to rent out. This year the partnership sold the building, recognizing a gain of $100,000. The partnership claimed and deducted straight-line depreciation of $35,000. Accelerated depreciation would have been $40,000. The partnership will report ordinary income of $35,000 and § 1231 gain of $65,000.

False. In contrast to question 6, the property is residential real estate and is consequently treated as § 1250 property. The partial recapture rule of § 1250 applies only if the taxpayer actually uses an accelerated method. In this case the taxpayer used straight-line, so the re-capture rules of § 1250 are not triggered. As a result, the entire $100,000 gain is a § 1231 gain. However, the gain will be a 25 percent gain to the extent of any unrecaptured § 1250 gain (i.e., the $35,000 straight-line depreciation).

Related Business Issues

installment sales of trade or Business ProPerty

As discussed in Chapter 14, gains on sales of trade or business property may be deferred using the installment sale method. However, depreciation recapture does not qualify for installment sale treatment. Thus, ordinary income from depreciation recapture must be re-ported in the year of sale—regardless of whether the seller received any payment in that year.49 Consequently, only the § 1231 gain from such sales will qualify for installment gain deferral.

Example 23

During the year, K sold a rental house for $90,000. According to the terms of the sale, K received $30,000 down and the balance in two equal installments of $30,000 over the next two years. K had purchased the house in 1986 for $60,000 and deducted $20,000 of accelerated depreciation. Had she used the straight-line method, the straight-line

49 § 453(i). See Chapter 14 for a detailed discussion of installment reporting.

Related Business Issues 17-39

depreciation would have been $15,000. K realizes a gain of $50,000 and has $5,000 of § 1250 recapture, computed as follows:

Amount realized . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $90,000Adjusted basis ($60,000 − $20,000) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . −40,000

Gain realized . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $50,000

Accelerated depreciation on residential real estate acquired before 1987 . . . . . . . . . . . . $20,000Hypothetical straight-line depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . −15,000

Excess depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,000

K must report all of the depreciation recapture, $5,000, as ordinary income in the year of the sale. In addition, she must report $15,000 of the remaining gain of $45,000 as a § 1231 gain under the installment sale rules for the year of sale, computed as follows:

Remaining gain, $45,000

Contract price, $90,000 3 $30,000 Payment received 5 $15,000 Gain recognized

Note that in computing the gross profit ratio, only the remaining gain is used in the numerator and not the entire $50,000 gain realized, as would normally be the case.

intangiBle Business assets

Historically, many purchased intangible assets were not subject to amortization for tax pur-poses. This was because the life of the assets was indefinite and the amortization deduction was indeterminable. However, § 197 currently allows the amortization (over 15 years) of most purchased intangibles acquired after August 11, 1993. No amortization is allowed, of course, for intangibles developed by the taxpayer.

For years, conventional thinking was that goodwill and similar intangibles were capital assets. A taxpayer who purchased or developed goodwill and similar intangibles generally recognized capital gain (or loss) to the extent the proceeds of the sale of a business were allocated to them.

All this became much more complex with the passage of § 197. Section 197(e) stipulates that upon the sale or disposition of § 197 assets, they are to be treated as depreciable property.

Private Letter Ruling [PLR] 200243002 brought clarity to this change. Under this rul-ing, intangible assets that are not subject to amortization are still treated as capital assets. This applies to assets placed in service on or before August 11, 1993, and any self developed goodwill and other intangibles (with no basis). However, intangibles purchased after August 11, 1993 (i.e. amortizable “§ 197 intangibles”) are to be treated as depreciable assets and upon sale they are subject to § 1245 and § 1231 treatment.

Under § 1245, any gain recognized will be ordinary income to the extent of amortiza-tion allowed. Any remaining gain or loss will be subject to the netting process under § 1231 and whatever treatment is required after the netting process.

disPositions of Business assets and tHe self-emPloyment tax

Gains and losses on the disposition of business assets do not increase or decrease self-em-ployment income. So, even though gains are ordinary income for income tax purposes to the extent of depreciation recapture under § 1245 and § 1250, these amounts are not included in self-employment income.


Tax Planning Considerations

timing of sales and otHer disPositions

Timing the sale of trade or business properties is very important and, from a tax perspective, can be critical. In the simplest case, if a taxpayer has a tax loss or is in a lower tax bracket, any contemplated sales at a gain should be considered to take advantage of the favorable tax result under § 1231. If tax rates are particularly high in the current year, loss transactions should be considered. Any net § 1231 loss is treated as an ordinary deduction for A.G.I. and avoids the $3,000 deduction limit imposed on net capital losses.

In addition, a net § 1231 gain qualifies as a long-term capital gain. For high-income taxpayers with no capital asset transactions or with a net capital gain in the current year, the net § 1231 gain qualifies for the maximum capital gains tax rate of 15 percent. The benefit can be even greater for a taxpayer with substantial capital losses for the year. Because the losses in excess of $3,000 would otherwise be suspended, any net § 1231 gain that would be offset by these losses can be currently recognized at no additional tax cost.

If a taxpayer has recognized or could recognize a § 1231 gain for the year and bene-fit from § 1231 treatment, additional sales of § 1231 property at a loss should be avoided. Because such losses must be netted against the gains, the favorable treatment of the gains is lost.

The look-back rule must be considered whenever a taxpayer is contemplating the tim-ing of sales of § 1231 gain and loss assets. If no § 1231 losses have been recognized in the past five years, the gain assets should be sold in the current year to receive the favorable treatment of net § 1231 gains. The loss assets can then be sold in the next year and be treated as ordinary losses. This plan will not work, however, if the loss assets are sold first.

Finally, the timing of casualty and theft gains and losses should be considered. Obviously, a taxpayer cannot control the timing of such losses—not legally, anyway. However, the § 1033 gain deferral rules discussed in Chapter 15 may offer some tax planning opportunity. Because this deferral provision is generally elective, the taxpayer should consider existing § 1231 gains or losses before making a decision to defer gain. For example, a taxpayer with substantial capital losses may decide not to defer a capital gain or § 1231 gain under § 1033 even though the involuntarily converted asset is to be replaced. Immediate recognition of the gain will not have any negative tax consequences because it can be offset by the existing capital losses. The replacement property will have a higher (cost) basis for future deprecia-tion. This plan is much more important to corporate taxpayers because excess capital losses can be carried forward only five years.

selecting dePreciation metHods

The accelerated cost recovery system provides taxpayers with several choices of deprecia-tion methods and conventions. For example, a taxpayer with depreciable personalty may elect to use the straight-line method and either the class life or a longer alternative life. For real estate, an alternative 40-year life may be used.

Effect of RecaptureGenerally, a taxpayer should adopt the most rapid method of depreciation available be-cause this results in a deferral of income taxes. Unless tax rates are expected to change significantly in the near future, the tax benefits produced by large depreciation deductions currently allow the taxpayer the use of the money that would otherwise have been used to pay income taxes. In addition, the availability of the like-kind exchange and involuntary conversion provisions eliminates the risk of depreciation recapture when the taxpayer plans to continue in business. It is also important to remember that, for noncorporate taxpayers, there is no depreciation recapture possibility for real estate placed in service after 1986. Because only the straight-line depreciation method can be used, there will be no excess depreciation. However, the unrecaptured § 1250 depreciation is taxed at 25 percent.

Section 179

LO.8Identify tax planningopportunities relatedto sales or otherdispositions of tradeor business property.

Tax Planning Considerations 17-41

As discussed in Chapter 9, any § 179 expense amount is treated as depreciation allowed. As a result, the comments above may also apply in deciding whether to claim the option to expense the cost of qualifying property. If more than one qualifying asset is placed in service during the year and their total cost exceeds the annual limit (or reduced limit), the taxpayer must select the assets to be expensed. Obviously, only the assets not expected to be sold should be considered for this option. Given the time value of money, however, it seems unlikely that any taxpayer should forgo the § 179 expense option—unless the additional record keeping is considered to outweigh the current tax benefit.

installment sales

Installment sales provide an excellent tax deferral possibility. Caution must be exercised, however, if trade or business property is to be sold under a deferred-payment arrangement. Because any depreciation recapture must be reported as income in the year of sale regardless of the amount of money received, taxpayers should require a cash down payment sufficient to pay any income taxes resulting from the depreciation recapture.

sales of Businesses

The sale of a business typically involves some recognition of intangible assets, whether it be goodwill, or some similar asset, or other assets such as customer lists. The buyer is gener-ally entitled to amortize the intangibles over 15 years. The seller may have ordinary income, capital gain, and/or § 1231 gain.

The IRS generally is required to recognize agreements between the buyer and the seller as to the value of the various assets in the sale of a business so long as they are reason-able. Thus in negotiating the value of the underlying assets, the buyer should consider the possible deductions related to the purchased assets. For depreciable assets and purchased intangibles, the deductions come in the form of depreciation and amortization. With respect to these assets, the buyer should also evaluate the effects of the depreciation recapture of the assets if they are to be sold in a short period of time.

disPositions of Business assets and tHe self-emPloyment tax

Gains on the disposition of business assets do not increase self-employment income. Similarly, losses do not reduce self-employment income. Generally speaking, foregoing allowable depreciation is not really optional since the basis of the depreciable assets must be reduced by depreciation allowed or allowable. So a taxpayer who does not feel like he or she needs the deduction, and realizes that the resulting gain if the asset is sold at a gain will be depreciation recapture, should claim it anyway!

Example 24

D purchased a machine for $4,000 in the current year. The machine qualifies for ex-pensing under § 197. D is uncertain as to whether she should claim the entire $4,000 since she expects to sell the machine for $3,200 the next tax year. Her dilemma in-volves the fact that the $4,000 is an ordinary deduction and the $3,200 is an ordinary gain. Why not just depreciate the machine? The reason is that by claiming the entire amount, she defers the tax on $3,200 for a year—assuming no change in her marginal tax rate.

Taxpayers paying self-employment tax should normally depreciate assets as rapidly as possible since the depreciation allowed will reduce the self-employment tax, but the future gain on the disposition of the asset is not includible in self-employment income.


Example 25

D, in the prior example, can deduct the full $4,000, reducing her income tax and her self-employment tax. However, when she sells the machine the next year, the gain is subject only to income tax (as ordinary income).

Problem Materials

DISCUSSION QUESTIONS

17-1 Section 1231 Assets. What are § 1231 assets? What is the required holding pe-riod? Does the § 1231 category of assets include § 1245 and § 1250 assets as well? Elaborate.

17-2 Excluded Assets. What type of property is excluded from § 1231 treatment?

17-3 Section 1231 Netting Process. Briefly describe the § 1231 netting process. Are per-sonal use assets included in this process?

17-4 Net § 1231 Gains. What is the appropriate tax treatment of net § 1231 gains? Are they offset by short-term capital losses? Can they be offset by capital loss carryovers from prior years?

17-5 Net § 1231 Losses. What is the appropriate tax treatment of net § 1231 losses? Are they subject to any annual limitation? Can they be used to create or increase a net operating loss for the year?

17-6 Certain Casualty or Theft Gains and Losses. Which casualty or theft gains and losses are included in the § 1231 netting process? What is the proper treatment of a net casualty or theft gain? What is the proper treatment of a net casualty or theft loss?

17-7 Section 1231 Look-Back Rule. Describe how the § 1231 look-back rule operates. Why do you think Congress enacted such a rule?

17-8 Section 1245 Property. What category of trade or business property is subject to § 1245? What depreciable real property has been included in this category?

17-9 Full Depreciation Recapture—§ 1245. What is meant by § 1245 recapture potential? Why is this rule sometimes called the full recapture rule? What is the lower limit of § 1245 recapture?

17-10 Section 1245 Recapture Potential. During the current year Z sold a vacuum used in his pool-cleaning business. The vacuum had cost $3,600 three years ago, and he had expensed the entire amount under § 179.

a. How much is the § 1245 recapture potential with respect to this vacuum? b. If the vacuum was sold for $900, what is the character of the gain?

17-11 Asset Classification. When will the sale or other disposition of depreciable equip-ment be subject to both § 1231 and § 1245? What is the appropriate treatment of any loss from the sale of such equipment?

17-12 Section 1245 Property. F gave property with § 1245 recapture potential to his daugh-ter, D. Will F be required to recapture any of the depreciation previously claimed? How must D characterize any gain she might recognize on a subsequent disposition of the property?

17-13 Section 1245 Recapture Potential. What happens to the § 1245 recapture potential when property is disposed of in a like-kind exchange?

Problem Materials 17-43

17-14 Section 179 Expense Treatment. Explain the proper tax treatment of any gain recog-nized on the disposition of an asset that the taxpayer had earlier elected to expense under § 179. Does this mean that any amounts ever deducted under § 179 will always be subject to recapture? Explain.

17-15 Section 1250 Property. Is land included in the definition of § 1250 property? Is any real property depreciated under the straight-line method included in this definition?

17-16 Section 1250 Property. Is nonresidential real estate acquired after 1980 always § 1250 property? Explain.

17-17 Section 1250 Property. Why will depreciable real property placed in service after 1986 never be subject to § 1250 recapture? How is the un-recaptured depreciation treated?

17-18 Section 1250 Recapture Potential. Why is § 1250 sometimes called the partial recap-ture rule? Will the § 1250 recapture potential ever simply disappear? Explain.

17-19 Section 1250 Recapture Potential. This year Y sold a duplex that she had rented out for several years. The house had cost $40,000 20 years earlier and depreciation expense of $27,000 has been claimed. Straight-line depreciation would have been $24,500.

a. How much is the § 1250 recapture potential with respect to the duplex? b. If the duplex was sold for $75,000, what is the character of Y’s gain and how is

it taxed?

17-20 Additional Recapture—§ 291. Briefly describe the additional depreciation recapture rule of § 291.

a. Which taxpayers are subject to this rule? b. Compare this to the special rate for un-recaptured depreciation on § 1250 prop-

erty for individual taxpayers.

17-21 Section 291 Recapture. Can a corporation that has always elected to use the straight-line depreciation method for all real property ever be subject to additional recapture under § 291? Explain.

17-22 Reporting § 1231 Transactions. What tax form does a taxpayer use to report the results of § 1231 transactions? How is any depreciation recapture reported on this form?

17-23 Planning § 1231 Transactions. Under what circumstances should a taxpayer with an involuntary conversion gain from business property consider not electing to defer the gain under § 1033?

17-24 Planning § 1231 Transactions. A taxpayer plans to trade in depreciable property in order to acquire new property but is quite disappointed to find that his old equipment is worth less than its unrecovered cost basis. He is currently in the top marginal tax bracket and has no capital gains or losses or other § 1231 transactions for the year. What tax advice would you offer this taxpayer concerning the planned exchange?

17-25 Installment Sales and Depreciation Recapture. Briefly describe how recapture is reported when either § 1245 property or § 1250 property is disposed of in an install-ment sale. What tax planning should a taxpayer undertake concerning such sales?

PROBLEMS

17-26 Characterizing Assets. Indicate whether the following gains and losses are § 1231 gains or losses or capital gains and losses or neither. Make your determination prior to the § 1231 netting process.

a. Printing press used in A’s business; held for three years and sold at a loss. b. Goodwill sold as part of the sale of B’s business


c. Vacant lot used five years as a parking lot in C’s business; sold at a gain d. House, 80 percent of which is D’s home and 20 percent of which is used as a

place of business; held 15 years and sold at a gain e. Camera used in E’s business; held for 10 months and sold at a gain f. Land used by F for 10 years as a farm and sold at a loss g. Personal residence sold at a loss

17-27 Section 1231. During the year H sold the following assets, both of which had been held for several years:

Asset Gain (Loss)

Vacant land held for investment $52,000

Equipment used in his business (12,000)

Determine how much capital gain or loss and the amount of ordinary income or loss that H will report for the year. At what rate will the gain, if any, be taxed?

17-28 Section 1231 Netting. G operates the Corner Bar and Grill as a sole proprietorship. During the year he sold the following assets, all of which had been held for several years:

Asset Gain (Loss)

IBM stock $(12,000)

Land and building used in the business 34,000

Equipment used in the business (3,000)

The building had been acquired in 1993. Straight-line depreciation claimed and de-ducted with respect to the building was $8,000. Straight-line depreciation on the equipment was $4,000. Determine how much capital gain or loss as well as the amount of ordinary income or loss that G will report for the year and explain how they will be taxed.

17-29 Involuntary Conversions and § 1231. Assume the same facts as in Problem 17-28. In addition, G’s records revealed the following information: • A portion of the grill’s parking lot was condemned by the city when it decided to

expand the adjacent street. G pocketed the cash and recognized a gain of $5,000. • A pool table was destroyed as part of a barroom brawl. G realized a casualty loss

of $2,000.

Determine how much capital gain or loss as well as the amount of ordinary income or loss that G will report for the year. At what rate will the recognized gain, if any, be taxed?

17-30 Section 1231 Hodgepodge. For 30 years Rae has operated The General Store, a hard-ware store in Columbus. Rae runs the business as a sole proprietorship. During the year, she recognized the following gains and losses from assets held several years:

1. Uninsured warehouse burned down: $10,000 loss 2. Equipment stolen $190,000 gain (ignore depreciation) 3. Parking lot sold: $120,000 gain 4. IBM stock sold capital loss of $70,000 5. Condemnation of land: $1,000 gain

Determine how much capital gain or loss as well as the amount of ordinary income or loss that Rae will report for the year. At what rate will the gain, if any, be taxed?


17-31 Section 1231 Lookback. J has recognized the following § 1231 gains and losses in the current year (2013) and since the inception of his business:

Year Net § 1231 Gain (Loss)

2013 $50,000

2012 12,000

2011 (35,000)

2010 0

2009 65,000

2007 (13,000)

How will J treat the $50,000 gain for the current year?

17-32 Section 1231—Timber. A owns timber land that she purchased in 1991. During the current calendar tax year, the timber was cut and A elected § 631 treatment for the gain. Her cost assignable to the timber was $25,000 and its fair market value on January 1 of this year was $40,000. The actual sales price of the cut timber when it was sold was $55,000.

a. How much is A’s gain or loss recognized and what is its character? b. Can A deduct the costs of cutting the timber?

17-33 Section 1231—Unharvested Crops. This year L sold her farmland, which she had owned for 20 years. L had made minor improvements to the farm and had used straightline depreciation to depreciate them. No personal property was sold with the farm. The sales price was $80,000 and L’s adjusted basis was $36,000. The un-harvested crops on the land represented $8,000 of the sales price, and L had spent $3,200 in producing the crop to the point of sale.

a. How does L report the gain or loss from the sale of the farm? b. If L has no other sales of trade or business property or of capital assets, how

much of the gain is included in her taxable income?

17-34 Section 1245 Recapture. During the current year, D sold a drill press he had used in his wood shop business for three years. D had purchased the press for $820 and had deducted depreciation of $476. Straight-line depreciation would have been $410. Determine the amount and character of gain or loss to D under each of the following circumstances below:

a. The press is sold for $500. b. The press is sold for $100. c. The press is sold for $900.

17-35 Section 1245 Recapture. This year N sold three different pieces of equipment used in her business:


Sales Price Cost

Depreciation Allowed

Processing machine 3 years $1,200 $1,400 $600

Work table 4 years 1,600 1,300 500

Automatic stapler 2 years 500 900 300

What are the amount and character of N’s gain or loss from these transactions?

17-36 Section 1245 Recapture. Fill in the missing information for each of the three inde-pendent sales of § 1245 assets identified below. Enter a dollar amount or n/a (for not applicable) in each blank space.

Assets

A B C

Sales price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $105 $ 90 $

Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 125 100

Depreciation allowed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 30

Depreciation recapture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

§ 1231 gain or (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (10)


17-37 Basis Reductions. Dr. T purchased a treadmill for use in his cardiology practice for $13,000 on August 14, 2011. T claimed § 179 expense of $10,000 and depreciation of $429 in 2010. The depreciation for 2012 and 2013 is $735 and $524, respectively. T sold the treadmill on January 13, 2013 for $3,500,

a. What are the amount and character of T’s gain on the sale? b. What would be your answer if the unit had been sold for $13,500?

17-38 Section 1250 Recapture. Fill in the missing information for each of the three inde-pendent sales of § 1250 assets identified below. Enter a dollar amount or n/a (for not applicable) in each blank space.

Assets

X Y Z

Sales price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $100 $ $200

Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135 100 100

Depreciation allowed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55 30

Straight-line depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

Depreciation recapture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 10

§ 1231 gain or (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 120

17-39 Real Property Acquired after 1986. V sold an office building in the current year that she had purchased for $60,000 two years earlier. Depreciation of $4,127 was claimed before the building was sold for $75,000. Determine V’s gain, its character and the rate at which it will be taxed?

17-40 Depreciation Recapture. K purchased a warehouse on January 18, 1986 for $50,000 ($10,000 allocable to the land and $40,000 allocable to the building). The property was 19-year realty and was depreciated using the 175 percent declining balance method and mid-month convention. The unit was sold on January 15 of the current year for $120,000 ($30,000 allocable to the land and $90,000 allocable to the build-ing). At the time the property was sold, the building was fully depreciated (i.e., K deducted depreciation of $40,000 while holding the property).

a. Determine K’s gain, its character and the rate at which it will be taxed. b. If K had used the straight-line method and a 19-year life under ACRS, the de-

preciation deductions would have been the same, $40,000. Determine K’s gain, its character and the rate at which it will be taxed.

c. What would be your answer to (b) if K were a corporation?

17-41 Depreciation Recapture. Happy Acres operates a small organic farm. In the current year, it sold some of its land including a barn for $500,000. The company purchased the property seven years earlier for $300,000. The barn is used for multiple pur-poses (storage of hay, tractors, equipment, animals). For MACRS, multi-purpose agricultural buildings are considered 20-year property and are depreciated using the 150% declining balance method (§ 168(b)(2)(A)). Assume accelerated depreciation deducted was $125,000 and straight-line depreciation would have been $105,000. For the following questions, ignore the land.

a. Compute the amount of gain realized and its character. b. What amount of the gain, if any, is taxed at 25 percent? c. What would your answer to (a) be if the company is a corporation?

17-42 Depreciation Recapture. JWP Development, an LLC, built a hotel in downtown Chicago in 1980 at a cost of $700,000. It depreciated the building using an ac-celerated method over a useful life of 40 years. This year it sold the building for $1,000,000. At the time of the sale, the company had deducted accelerated depre-ciation of $400,000. Straight-line depreciation on the building would have been $150,000. (Do not try to verify these amounts.)

a. What is the amount of the company’s gain and what is its character? b. What amount of the gain, if any, will be taxed at a 25 percent rate? c. If the company had used the straight-line method, what would be the amount

and character of the gain? At what rate would the gain be treated? d. What would be your answer to (a) if JWP were a corporation?


17-43 Installment Sales and Recapture. Assume the same facts as in Problem 17-42 ex-cept that Z sold the property under an installment contract with $100,000 down and $100,000 in each of the next nine years along with reasonable interest. How much gain would Z report in the year of sale and the following year and what is its character?

17-44 Unrecaptured § 1250 Gain. B purchased a small warehouse for $45,000 in 2009. This year he sold the property for $62,000. He had deducted straight-line deprecia-tion of $6,500 on the property prior to the sale. What is the amount of gain, if any, and how will it be taxed?

17-45 Twenty-five Percent Gains. V had the following gains and losses for the current year:

§ 1250 recapture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,000Net § 1231 gains . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000Net short-term capital loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . (3,000)

V’s § 1231 gain was from a building that was held 15 years. The total depreciation allowed was $5,000. How much are V’s 15 percent gains and 25 percent gains, respectively?

17-46 Section 1231 Gain and Look-Back Rule. R sold land and a building used in farming for many years at a gain of $30,000 during 2013. No other sales or dispositions of § 1231 assets were made during the year. The § 1250 depreciation recapture for the building was zero and the unrecaptured depreciation was $1,000.

a. How is R’s gain to be reported if he had a net § 1231 gain of $10,000 in 2010, a net § 1231 loss of $12,000 in 2011, and no § 1231 transactions in 2012?

b. How would your answer to (a) differ if the sale of the property had resulted in a loss of $7,500?

17-47 Section 1231 and Depreciation Recapture. Fill in the missing information for each of the separate sales of § 1231 assets indicated below. Enter a dollar amount or n/a (for not applicable) in each blank space.

Land Building Machine Machine

Sales price . . . . . . . . . . . . . . . . . . . . . . . . . . . $100 $ $90 $

Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140 100 125 100

Depreciation allowed . . . . . . . . . . . . . . . . . . 0 30 30

Straight-line depreciation . . . . . . . . . . . . . . . 0 20

Depreciation recapture . . . . . . . . . . . . . . . . .

§ 1231 gain or (loss) . . . . . . . . . . . . . . . . . . . 30 (10) 5

17-48 Depreciation Recapture and the § 1231 Netting Process. T had three § 1231 transac-tions during the current year. All of the assets were held for several years.

a. Theft of electric cart used on business premises. The cart was worth $600, origi-nally cost $800, and had an adjusted basis of $425.

b. Sale of equipment used in manufacturing. The equipment sold for $5,500, origi-nally cost $8,000, and had an adjusted basis of $4,250.

c. Sale of land and a small building used for storage. The property was sold for $60,000, originally cost $56,000, and had an adjusted basis of $42,500. Straightline depreciation was claimed on the building.

Determine the amount of ordinary income or loss and capital gain or loss that T must report from these transactions for the current year.

17-49 Section 1231 Transactions. K has the following business assets that she is interested in selling in either 2013 or 2014.

Fair Market Value Basis

Manufacturing equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . $220,000 $400,000Factory building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 350,000 220,000Land used for factory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 450,000 120,000


Straight-line depreciation of $60,000 was claimed on the factory. K has never sold any other § 1231 assets.

a. What are the tax results if K sells the land and building in 2013 and the equip-ment in 2014?

b. What are the tax results if K sells the equipment in 2013 and the land and build-ing in 2014?

c. What are the tax results if K sells all the assets in 2013?

17-50 Comprehensive Problem for Capital Asset and Trade or Business Property Transactions. T owned a number of apartment units and sold several properties re-lated to that trade or business during the current year as follows:


Sales Price Cost

Depreciation Allowed Method

Apartment unit, including land (straight-line depreciation 5 $2,400)

3 years $65,000 $24,000 $3,000 DB

Lawn tractor 5 years 1,000 3,000 2,600 SL

Spray painter 2 years 500 1,400 600 SL

During a severe winter storm, T also lost a depreciable motor scooter used in his business. The scooter, which was owned by T for two years and used exclusively in the business, had cost $2,600 and had an adjusted basis of $1,750.

In addition, T sold several capital assets during the current year as follows:

Description Holding Period Sales Price Adjusted Basis

100 shares LM Corp 16 months $2,000 $1,000

75 shares PL, Inc 8 months 1,600 6,000

Silver ingots 6 years 2,600 6,000

Assuming T has never deducted § 1231 losses before, calculate the following amounts based on the above information:

a. The amount of § 1245 recapture and § 1250 recapture, if any. b. The net § 1231 gain or loss. c. The capital gain or loss and the rate at which it is taxed. d. The net short-term capital gain or loss. e. The overall impact of the above transactions on T’s adjusted gross income.

17-51 Netting Gains and Losses. G had the following gains and losses for the current cal-endar year:

DFG Corporation stock held 3 years . . . . . . . . . . . . . . . . . . . . . $4,000Gold held 6 years . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (5,000)Sale of business building: § 1250 recapture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500 § 1231 gain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000

Depreciation of $7,500 had been claimed on the building. What is the character of these gains in calculating the capital gains tax?

17-52 Capital Gains Tax. C, an unmarried head of household, has the following gains and losses for the current taxable year:

GHJ, Inc. stock held 16 months . . . . . . . . . . . . . . . . . . . . . . . . ($3,000)Land held for investment 15 years . . . . . . . . . . . . . . . . . . . . . . 4,000Sale of business real estate held 15 years: § 1250 recapture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,800 Net § 1231 gain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,250


Depreciation claimed on the real estate was $7,800. C’s taxable income (properly calculated and including the information above) is $121,900. How much is C’s in-come tax for the current calendar year?

17-53 Comprehensive Problem with Sales of Business Use Assets. O and P are married. They have no dependents and elect to file jointly for the current year. They recently decided to retire, sell their home, and try renting for a while. Their income and re-lated transactions for the year follow:

Ordinary income from business . . . . . . . . . . . . . . . . . . . . . . . . $ 45,200Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,100Sale of personal residence of 20 years: Sales price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $760,000 Selling costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43,000 Adjusted basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 195,000Sale of business: § 1245 recapture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000 § 1250 recapture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26,000 § 1231 gain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90,000Gain on sale of stock held 5 years . . . . . . . . . . . . . . . . . . . . . . . 16,000Itemized deductions (after 2 percent cutback) . . . . . . . . . . . . . 23,400

O and P had claimed depreciation on the § 1245 property and the § 1250 prop-erty in the amount of $25,000 and $56,000, respectively. Calculate O and P’s ad-justed gross income, taxable income, and gross income tax for the current year.

17-54 Sections 1231 and 1245 Property. The terms § 1231 property and § 1245 property are often used interchangeably. However, there are times when a specific asset can be classified as (1) both § 1231 and § 1245 property; (2) only § 1231 property; or (3) only § 1245 property. Based on the values assigned to the letters below, indicate the appropriate classification for each of the following mathematical expressions.

Let X 5 asset’s original cost Y 5 depreciation claimed Z 5 asset’s adjusted basis T 5 amount realized on sale

a. If T Z, asset is §_______ property. b. If T > X, asset is §_______property. c. If X > T < Z, asset is §_______property. d. If Y > T > Z, asset is §_______property.

17-55 Section 1231 and § 1250 Property. It is possible that (1) both § 1231 and § 1250 apply to the sale of depreciable real property, (2) only § 1250 applies, or (3) only § 1231 applies. Based on the values assigned to the letters below, indicate which Code sections apply for each of the following mathematical expressions.

Let X 5 asset’s original cost Y 5 depreciation claimed Z 5 asset’s adjusted basis T 5 amount realized on sale S 5 amount of straight-line depreciation

a. If Y > S and T Z, §_______ applies. b. If Y > S and T > X, §__________ applies. c. If Y 5 S, §_________ applies. d. If Y > S and (T – Z) (Y – S), § applies.

17-56 Sale of Property Converted from Personal Use—Comprehensive Problem. L owned and used a house as her personal residence since she purchased it in 2008 for $110,000. On February 11, 2011, when it was worth $85,000, L moved out and converted the


property into a rental property. She rented the house until December 15, 2013, when it was sold for $104,500.

a. Determine L’s depreciation deductions for the rental property from the time it was converted in 2011 until it was sold in 2013. Ignore land value.

b. What are the amount and character of L’s gain or loss to be recognized from the sale?

17-57 Sale of Property Converted to Personal Use—Comprehensive Problem. Z purchased a computer system with peripherals for $14,500 on August 12, 2010. The system was used exclusively in his business. In October 2013, when the computer was worth $8,200, Z closed the business and began using the unit for personal purposes.

a. Determine Z’s depreciation deductions for the computer system from the time it was purchased until it was converted to personal use, assuming that he elected the maximum § 179 expensing option for other assets placed into service in 2010.

b. Assume the computer system was sold for $5,400 on May 15, 2013 rather than being converted to personal use. What are the amount and character of Z’s loss?

TAX RESEARCH PROBLEMS

17-58 Capital Assets versus § 1231 Assets. R inherited a residence that had been used ex-clusively by her grandmother as a principal residence for 30 years. Upon receiving the property, R immediately offered the property for rent and rented to several ten-ants. After several months, R encountered an interesting potential business venture that would require a substantial capital investment. After an agonizing decision, she proceeded to sell her inherited rental unit. The unit was sold at a loss and R deducted the loss under § 1231. Since she had no § 1231 gains, the loss was deducted as an ordinary deduction. Is the treatment R chose the appropriate treatment for the loss? Does the character of the property to her grandmother carry over to R, resulting in disallowance of the loss or capital loss treatment?

Research aids:Campbell v. Comm., 5 T.C. 272 (1945).Crawford v. Comm., 16 T.C. 78 (1951), acq. 1951-2 C.B. 2.

17-59 Business Use of Personal Residence. J purchased a home in March 1992 for $120,000. Twenty percent of its cost was attributable to the land. From the date of purchase until March 2008, 20 percent of the house was used as a home-office, the costs of which were properly deducted annually (including depreciation). The home was used exclusively as J’s residence from April 2008 until the house was sold for $325,000 on November 15, 2013.

a. J used the straight-line method and the normal useful life of 32.5 years (appli-cable at the time, it would be 39 years for property placed in service currently). What amount of depreciation did he claim over the 15-year period that the prop-erty was used as a home-office?

b. Is there any depreciation recapture to be reported if gain is reported on the sale? c. Is there depreciation recapture to be reported if all or part of the gain is excluded?

Documents

Property Transactions: Dispositions of Trade or Business ... · PDF filegain. If there is a net loss, it is treated as an ordinary loss. In short, § 1231 allows taxpayers to have