3. Ordinary or
Capital Gain or Loss for Business Property
When you dispose of business property, your taxable
gain or loss is usually a section 1231 gain or loss. Its
treatment as ordinary or capital is determined under
rules for section 1231 transactions.
When you dispose of depreciable property (section
1245 property or section 1250 property) at a gain, you
may have to recognize all or part of the gain as
ordinary income under the depreciation recapture rules.
Any remaining gain is a section 1231 gain.
Topics - This
chapter discusses:
Useful Items - You
may want to see:
Publication
-
534 Depreciating Property Placed in
Service Before 1987
-
537 Installment Sales
-
551 Basis of Assets
-
946 How To Depreciate
Property
-
954 Tax Incentives for Distressed
Communities
See chapter 5 for information about getting
publications and forms.
Section 1231 Gains
and Losses
Section 1231 gains and losses are the taxable gains
and losses from section 1231 transactions. Their
treatment as ordinary or capital depends on whether you
have a net gain or a net loss from all your section 1231
transactions.
If
you have a gain from a section 1231 transaction, first
determine whether any of the gain is ordinary income
under the depreciation recapture rules (explained
later). Do not take that gain into account as section
1231 gain.
Section 1231 transactions.
The following transactions result in gain or
loss subject to section 1231 treatment.
-
Sales or exchanges of real property or depreciable
personal property. This property must be used in a
trade or business and held longer than 1 year.
Generally, property held for the production of rents
or royalties is considered to be used in a trade or
business. Depreciable personal property includes
amortizable section 197 intangibles (described in
chapter 2 under Other
Dispositions).
-
Sales or exchanges of leaseholds. The leasehold
must be used in a trade or business and held longer
than 1 year.
-
Sales or exchanges of cattle and horses. The cattle
and horses must be held for draft, breeding, dairy, or
sporting purposes and held for 2 years or longer.
-
Sales or exchanges of other livestock. This
livestock does not include poultry. It must be held
for draft, breeding, dairy, or sporting purposes and
held for 1 year or longer.
-
Sales or exchanges of unharvested crops. The crop and land
must be sold, exchanged, or involuntarily converted at
the same time and to the same person and the land must
be held longer than 1 year. The taxpayer cannot keep
any right or option to directly or indirectly
reacquire the land (other than a right customarily
incident to a mortgage or other security transaction).
Growing crops sold with a lease on the land, though
sold to the same person in the same transaction, are
not included.
-
Cutting of timber or disposal of timber, coal, or
iron ore. The
cutting or disposal must be treated as a sale, as
described in chapter 2 under Timber and Coal and Iron Ore.
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Condemnations. The condemned property must have been
held longer than 1 year. It must be business property
or a capital asset held in connection with a trade or
business or a transaction entered into for profit,
such as investment property. It cannot be property
held for personal use.
-
Casualties and thefts. The casualty or theft must have
affected business property, property held for the
production of rents and royalties, or investment
property (such as notes and bonds). You must have held
the property longer than 1 year. However, if your
casualty or theft losses are more than your casualty
or theft gains, neither the gains nor the losses are
taken into account in the section 1231 computation.
For more information on casualties and thefts, see
Publication 547, Casualties, Disasters, and Thefts.
Property for sale to customers.
A sale, exchange, or involuntary conversion
of property held mainly for sale to customers is not a
section 1231 transaction. If you will get back all, or
nearly all, of your investment in the property by
selling it rather than by using it up in your business,
it is property held mainly for sale to customers.
Example.
You manufacture and sell steel cable, which you
deliver on returnable reels that are depreciable
property. Customers make deposits on the reels, which
you refund if the reels are returned within a year. If
they are not returned, you keep each deposit as the
agreed-upon sales price. Most reels are returned within
the 1-year period. You keep adequate records showing
depreciation and other charges to the capitalized cost
of the reels. Under these conditions, the reels are not
property held for sale to customers in the ordinary
course of your business. Any gain or loss resulting from
their not being returned may be capital or ordinary,
depending on your section 1231 transactions.
Copyrights. The sale of a copyright,
a literary, musical, or artistic composition, or similar
property is not a section 1231 transaction if your
personal efforts created the property, or if you
acquired the property in a way that entitled you to the
basis of the previous owner whose personal efforts
created it (for example, if you receive the property as
a gift). The sale of such property results in ordinary
income and generally is reported in Part II of Form
4797.
Treatment as ordinary or capital.
To determine the treatment of section 1231
gains and losses, combine all your section 1231 gains
and losses for the year.
-
If you have a net section 1231 loss, it is ordinary
loss.
-
If you have a net section 1231 gain, it is ordinary
income up to the amount of your nonrecaptured section
1231 losses from previous years. The rest, if any, is
long-term capital gain.
Nonrecaptured section 1231
losses. Your nonrecaptured section
1231 losses are your net section 1231 losses for the
previous 5 years that have not been applied against a
net section 1231 gain by treating the gain as ordinary
income. These losses are applied against your net
section 1231 gain beginning with the earliest loss in
the 5-year period.
Example.
Ashley, Inc., a graphic arts company, is a calendar
year corporation. In 2001, it had a net section 1231
loss of $8,000. For tax years 2003 and 2004, the company
has net section 1231 gains of $5,250 and $4,600,
respectively. In figuring taxable income for 2003,
Ashley treated its net section 1231 gain of $5,250 as
ordinary income by recapturing $5,250 of its $8,000 net
section 1231 loss from 2001. In 2004 it applies its
remaining net section 1231 loss, $2,750 ($8,000 -
$5,250) against its net section 1231 gain, $4,600. For
2004, the company reports $2,750 as ordinary income and
$1,850 ($4,600 - $2,750) as long-term capital gain.
If you dispose of depreciable or amortizable property
at a gain, you may have to treat all or part of the gain
(even if otherwise nontaxable) as ordinary income.
To figure any gain that
must be reported as ordinary income, you must keep
permanent records of the facts necessary to figure the
depreciation or amortization allowed or allowable on
your property. This includes the date and manner of
acquisition, cost or other basis, depreciation or
amortization, and all other adjustments that affect
basis.
On property you acquired in a nontaxable exchange or
as a gift, your records also must indicate the following
information.
-
Whether the adjusted basis was figured using
depreciation or amortization you claimed on other
property.
-
Whether the adjusted basis was figured using
depreciation or amortization another person
claimed.
Corporate distributions.
For information on property distributed by
corporations, see Distributions
to Shareholders in Publication 542,
Corporations.
General asset accounts.
Different rules apply to dispositions of
property you depreciated using a general asset account.
For information on these rules, see section
1.168(i)-1(e) of the regulations.
A gain on the disposition of section 1245 property is
treated as ordinary income to the extent of depreciation
allowed or allowable on the property. See Gain Treated as Ordinary Income,
later.
Any gain recognized that is more than the part that
is ordinary income from depreciation is a section 1231
gain. See Treatment as ordinary
or capital under Section 1231 Gains and
Losses, earlier.
Section 1245 property. Section
1245 property includes any property that is or has been
subject to an allowance for depreciation or amortization
and that is any of the following types of property.
-
Personal property (either tangible or
intangible).
-
Other tangible property (except buildings and their
structural components) used as any of the following.
-
An integral part of manufacturing, production, or
extraction, or of furnishing transportation,
communications, electricity, gas, water, or sewage
disposal services.
-
A research facility in any of the activities in
(a).
-
A facility in any of the activities in (a) for
the bulk storage of fungible
commodities.
-
That part of real property (not included in (2))
with an adjusted basis that was reduced by certain
amortization deductions (including those for certified
pollution control facilities, childcare facilities,
removal of architectural barriers to persons with
disabilities and the elderly, or reforestation
expenses) or a section 179 deduction.
-
Single purpose agricultural (livestock) or
horticultural structures.
-
Storage facilities (except buildings and their
structural components) used in distributing petroleum
or any primary product of petroleum.
Buildings and structural
components. Section 1245 property
does not include buildings and structural components. Do
not treat structures that are essentially items of
machinery or equipment as buildings and structural
components. Also, do not treat as buildings structures
that house property used as an integral part of an
activity if the structures' use is so closely related to
the property's use that the structures can be expected
to be replaced when the property they initially house is
replaced. The fact that the structures are specially
designed to withstand the stress and other demands of
the property and the fact that the structures cannot be
used economically for other purposes indicate that they
are closely related to the use of the property they
house. Structures such as oil and gas storage tanks,
grain storage bins, silos, fractionating towers, blast
furnaces, basic oxygen furnaces, coke ovens, brick
kilns, and coal tipples are not treated as buildings.
Facility for bulk storage of fungible
commodities. This term includes oil
or gas storage tanks and grain storage bins. Bulk
storage means the storage of a commodity in a large mass
before it is used. For example, if a facility is used to
store oranges that have been sorted and boxed, it is not
used for bulk storage. To be fungible, a commodity must
be such that one part may be used in place of another.
Stored materials that vary in
composition, size, and weight are not fungible.
Materials are not fungible if one part cannot be used in
place of another part and the materials cannot be
estimated and replaced by simple reference to weight,
measure, and number. For example, the storage of
different grades and forms of aluminum scrap is not
storage of fungible commodities.
Gain Treated as
Ordinary Income
The gain treated as ordinary income on the sale,
exchange, or involuntary conversion of section 1245
property, including a sale and leaseback transaction, is
the lesser of the following amounts.
-
The depreciation and amortization allowed or
allowable on the property.
-
The gain realized on the disposition (the amount
realized from the disposition minus the adjusted basis
of the property).
A limit on this amount for gain on like-kind
exchanges and involuntary conversions is explained
later.
For any other disposition of section 1245 property,
ordinary income is the lesser of (1) earlier or the
amount by which its fair market value is more than its
adjusted basis. See Gifts
and Transfers at
Death, later.
Use Part III of Form 4797 to figure the ordinary
income part of the gain.
Depreciation taken on other property or
taken by other taxpayers. Depreciation
and amortization include the amounts you claimed on the
section 1245 property as well as the following
depreciation and amortization amounts.
-
Amounts you claimed on property you exchanged for,
or converted to, your section 1245 property in a
like-kind exchange or involuntary conversion. See
Caution, below.
-
Amounts a previous owner of the section 1245
property claimed if your basis is determined with
reference to that person's adjusted basis (for
example, the donor's depreciation deductions on
property you received as a gift).
Simpler rules
apply for section 1245 property you acquired after
February 27, 2004. If you use MACRS, you can elect to
continue depreciating the property exchanged or
involuntarily converted as if the transfer had not
occurred. The excess basis, if any, is treated as newly
placed in service property. For details, see Figuring
the Deduction for Property Acquired in a Nontaxable
Exchange in chapter 4 of Publication 946.
Depreciation and amortization.
Depreciation and amortization that must be
recaptured as ordinary income include (but are not
limited to) the following items.
-
Ordinary depreciation deductions.
-
The 30% special depreciation allowance for property
acquired after September 10, 2001.
-
The 50% special depreciation allowance for property
acquired after May 5, 2003.
-
Amortization deductions for all the following
costs.
-
Acquiring a lease.
-
Lessee improvements.
-
Pollution control facilities.
-
Reforestation expenses.
-
Section 197 intangibles.
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Childcare facility expenses made before 1982.
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Franchises, trademarks, and trade names acquired
before August 11, 1993.
-
The section 179 deduction.
-
Deductions for all the following costs.
-
Removing barriers to the disabled and the
elderly.
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Tertiary injectant expenses.
-
Depreciable clean-fuel vehicles and refueling
property (minus the amount of any recaptured
deduction).
-
Environmental cleanup costs.
-
Any basis reduction for the investment credit
(minus any basis increase for credit recapture).
-
Any basis reduction for the qualified electric
vehicle credit (minus any basis increase for credit
recapture).
Example.
You file your returns on a calendar year basis. In
February 2002, you bought and placed in service for 100%
use in your business a light-duty truck (5-year
property) that cost $10,000. You used the half-year
convention and your MACRS deductions for the truck were
$2,000 in 2002 and $3,200 in 2003. You did not take the
section 179 deduction. You sold the truck in May 2004
for $7,000. The MACRS deduction in 2004, the year of
sale, is $960 (1/2 of $1,920). Figure the gain treated
as ordinary income as follows.
Depreciation on other tangible
property. You must take into account
depreciation during periods when the property was not
used as an integral part of an activity or did not
constitute a research or storage facility, as described
earlier under Section 1245
property.
For example, if depreciation
deductions taken on certain storage facilities amounted
to $10,000, of which $6,000 is from the periods before
their use in a prescribed business activity, you must
use the entire $10,000 in determining ordinary income
from depreciation.
Depreciation allowed or allowable.
The greater of the depreciation allowed or
allowable is generally the amount to use in figuring the
part of gain to report as ordinary income. If, in prior
years, you have consistently taken proper deductions
under one method, the amount allowed for your prior
years will not be increased even though a greater amount
would have been allowed under another proper method. If
you did not take any deduction at all for depreciation,
your adjustments to basis for depreciation allowable are
figured by using the straight line method.
This treatment applies only when
figuring what part of gain is treated as ordinary income
under the rules for section 1245 depreciation recapture.
Multiple asset accounts. In
figuring ordinary income from depreciation, you can
treat any number of units of section 1245 property in a
single depreciation account as one item if the total
ordinary income from depreciation figured by using this
method is not less than it would be if depreciation on
each unit were figured separately.
Example.
In one transaction you sold 50 machines, 25 trucks,
and certain other property that is not section 1245
property. All of the depreciation was recorded in a
single depreciation account. After dividing the total
received among the various assets sold, you figured that
each unit of section 1245 property was sold at a gain.
You can figure the ordinary income from depreciation as
if the 50 machines and 25 trucks were one item.
However, if 5 of the trucks had been sold at a loss,
only the 50 machines and 20 of the trucks could be
treated as one item in determining the ordinary income
from depreciation.
Normal retirement.
The normal retirement of section 1245
property in multiple asset accounts does not require
recognition of gain as ordinary income from depreciation
if your method of accounting for asset retirements does
not require recognition of that gain.
Gain on the disposition of section 1250 property is
treated as ordinary income to the extent of additional
depreciation allowed or allowable on the property. To
determine the additional depreciation on section 1250
property, see Additional
Depreciation, later.
Section 1250 property defined.
This includes all real property that is
subject to an allowance for depreciation and that is not
and never has been section 1245 property. It includes a
leasehold of land or section 1250 property subject to an
allowance for depreciation. A fee simple interest in
land is not included because it is not depreciable.
If your section 1250 property becomes
section 1245 property because you change its use, you
can never again treat it as section 1250 property.
If you hold section 1250 property longer than 1 year,
the additional depreciation is the actual depreciation
adjustments that are more than the depreciation figured
using the straight line method. For a list of items
treated as depreciation adjustments, see Depreciation and amortization
under Gain Treated
as Ordinary Income, earlier.
If you hold section 1250 property for 1 year or less,
all the depreciation is additional depreciation.
You will not have additional depreciation if any of
the following conditions apply to the property disposed
of.
-
You figured depreciation for the property using the
straight line method or any other method that does not
result in depreciation that is more than the amount
figured by the straight line method; you held the
property longer than 1 year; and, if the property was
qualified New York Liberty Zone property, you made a
timely election not to claim the 30% or 50% special
depreciation allowance. In addition, if the property
was in a renewal community, you must not have elected
to claim a commercial revitalization deduction as
figured under section 1400I of the Internal Revenue
Code.
-
The property was residential low-income rental
property you held for 16 2/3 years or longer. For
low-income rental housing on which the special
60-month depreciation for rehabilitation expenses was
allowed, the 16 2/3 years start when the rehabilitated
property is placed in service.
-
You chose the alternate ACRS method for the
property, which was a type of 15-, 18-, or 19-year
real property covered by the section 1250 rules.
-
The property was residential rental property or
nonresidential real property placed in service after
1986 (or after July 31, 1986, if the choice to use
MACRS was made); you held it longer than 1 year; and,
if the property was qualified New York Liberty Zone
property, you made a timely election not to claim the
30% or the 50% special depreciation allowance. These
properties are depreciated using the straight line
method. In addition, if the property was in a renewal
community, you must not have elected to claim a
commercial revitalization deduction as figured under
section 1400I of the Internal Revenue Code.
Depreciation taken by other taxpayers
or on other property. Additional
depreciation includes all depreciation adjustments to
the basis of section 1250 property whether allowed to
you or another person (as carryover basis property).
Example.
Larry Johnson gives his son section 1250 property on
which he took $2,000 in depreciation deductions, of
which $500 is additional depreciation. Immediately after
the gift, the son's adjusted basis in the property is
the same as his father's and reflects the $500
additional depreciation. On January 1 of the next year,
after taking depreciation deductions of $1,000 on the
property, of which $200 is additional depreciation, the
son sells the property. At the time of sale, the
additional depreciation is $700 ($500 allowed the father
plus $200 allowed the son).
Depreciation allowed or allowable.
The greater of depreciation allowed or
allowable (to any person who held the property if the
depreciation was used in figuring its adjusted basis in
your hands) generally is the amount to use in figuring
the part of the gain to be reported as ordinary income.
If you can show that the deduction allowed for any tax
year was less than the amount allowable, the lesser
figure will be the depreciation adjustment for figuring
additional depreciation.
Retired or demolished property.
The adjustments reflected in adjusted basis
generally do not include deductions for depreciation on
retired or demolished parts of section 1250 property
unless these deductions are reflected in the basis of
replacement property that is section 1250 property.
Example.
A wing of your building is totally destroyed by fire.
The depreciation adjustments figured in the adjusted
basis of the building after the wing is destroyed do not
include any deductions for depreciation on the destroyed
wing unless it is replaced and the adjustments for
depreciation on it are reflected in the basis of the
replacement property.
Figuring straight line
depreciation. The useful life and
salvage value you would have used to figure straight
line depreciation are the same as those used under the
depreciation method you actually used. If you did not
use a useful life under the depreciation method actually
used (such as with the units-of-production method) or if
you did not take salvage value into account (such as
with the declining balance method), the useful life or
salvage value for figuring what would have been the
straight line depreciation is the useful life and
salvage value you would have used under the straight
line method.
Salvage value and useful life are not
used for the ACRS method of depreciation. Figure
straight line depreciation for ACRS real property by
using its 15-, 18-, or 19-year recovery period as the
property's useful life.
The straight line method is applied
without any basis reduction for the investment credit.
Property held by lessee.
If a lessee makes a leasehold improvement,
the lease period for figuring what would have been the
straight line depreciation adjustments includes all
renewal periods. This inclusion of the renewal periods
cannot extend the lease period taken into account to a
period that is longer than the remaining useful life of
the improvement. The same rule applies to the cost of
acquiring a lease.
The term renewal period means any
period for which the lease may be renewed, extended, or
continued under an option exercisable by the lessee.
However, the inclusion of renewal periods cannot extend
the lease by more than two-thirds of the period that was
the basis on which the actual depreciation adjustments
were allowed.
Rehabilitation expenses.
A part of the special 60-month depreciation
adjustment allowed for rehabilitation expenses incurred
before 1987 in connection with low-income rental housing
is additional depreciation. The additional depreciation
is the special depreciation adjustments that are more
than the adjustments that would have resulted if the
straight line method, normal useful life, and salvage
value had been used.
Example.
On January 7, 2001, Fred Plums, a calendar year
taxpayer, sold real property in which the entire basis
was from rehabilitation expenses of $40,000 incurred in
1985. The property was placed in service on January 3,
1986. Under the special depreciation provisions for
rehabilitation expenses, the property was depreciated
under the straight line method using a useful life of 60
months (5 years) and no salvage value. If Fred had used
the regular straight line method, he would have used a
salvage value of $4,000 and a useful life of 15 years,
and would have had a depreciable basis of $36,000.
Depreciation under the straight line method would have
been $2,400 each year (1/15 x $36,000). On January 1,
2001, the additional depreciation for the property was
$4,000, figured as follows.
The applicable percentage used to figure the ordinary
income because of additional depreciation depends on
whether the real property you disposed of is
nonresidential real property, residential rental
property, or low-income housing. The percentages for
these types of real property are as follows.
Nonresidential real property.
For real property that is not residential rental
property, the applicable percentage for periods after
1969 is 100%. For periods before 1970, the percentage is
zero and no ordinary income because of additional
depreciation before 1970 will result from its
disposition.
Residential rental property. For
residential rental property (80% or more of the gross
income is from dwelling units) other than low-income
housing, the applicable percentage for periods after
1975 is 100%. The percentage for periods before 1976 is
zero. Therefore, no ordinary income because of
additional depreciation before 1976 will result from a
disposition of residential rental property.
Low-income housing. Low-income housing includes all the
following types of residential rental property.
-
Federally assisted housing projects if the mortgage
is insured under section 221(d)(3) or 236 of the
National Housing Act or housing financed or assisted
by direct loan or tax abatement under similar
provisions of state or local laws.
-
Low-income rental housing for which a depreciation
deduction for rehabilitation expenses was allowed.
-
Low-income rental housing held for occupancy by
families or individuals eligible to receive subsidies
under section 8 of the United States Housing Act of
1937, as amended, or under provisions of state or
local laws that authorize similar subsidies for
low-income families.
-
Housing financed or assisted by direct loan or
insured under Title V of the Housing Act of
1949.
The applicable percentage for
low-income housing is 100% minus 1% for each full month
the property was held over 100 full months. If you have
held low-income housing at least 16 years and 8 months,
the percentage is zero and no ordinary income will
result from its disposition.
Foreclosure. If low-income housing is
disposed of because of foreclosure or similar
proceedings, the monthly applicable percentage reduction
is figured as if you disposed of the property on the
starting date of the proceedings.
Example.
On June 1, 1992, you acquired low-income housing
property. On April 3, 2003 (130 months after the
property was acquired), foreclosure proceedings were
started on the property and on December 3, 2004 (150
months after the property was acquired), the property
was disposed of as a result of the foreclosure
proceedings. The property qualifies for a reduced
applicable percentage because it was held more than 100
full months. The applicable percentage reduction is 30%
(130 months minus 100 months) rather than 50% (150
months minus 100 months) because it does not apply after
April 3, 2003, the starting date of the foreclosure
proceedings. Therefore, 70% of the additional
depreciation is treated as ordinary income.
Holding period.
The holding period used to figure the
applicable percentage for low-income housing generally
starts on the day after you acquired it. For example, if
you bought low-income housing on January 1, 1988, the
holding period starts on January 2, 1988. If you sold it
on January 2, 2004, the holding period is exactly 192
full months. The applicable percentage for additional
depreciation is 8%, or 100% minus 1% for each full month
the property was held over 100 full months.
Holding period for constructed,
reconstructed, or erected property.
The holding period used to figure the
applicable percentage for low-income housing you
constructed, reconstructed, or erected starts on the
first day of the month it is placed in service in a
trade or business, in an activity for the production of
income, or in a personal activity.
Property acquired by gift or received
in a tax-free transfer. For
low-income housing you acquired by gift or in a tax-free
transfer the basis of which is figured by reference to
the basis in the hands of the transferor, the holding
period for the applicable percentage includes the
holding period of the transferor.
If the adjusted basis of the property
in your hands just after acquiring it is more than its
adjusted basis to the transferor just before
transferring it, the holding period of the difference is
figured as if it were a separate improvement. See Low-Income Housing With Two or More
Elements, next.
Low-Income Housing
With Two or More Elements
If you dispose of low-income housing property that
has two or more separate elements, the applicable
percentage used to figure ordinary income because of
additional depreciation may be different for each
element. The gain to be reported as ordinary income is
the sum of the ordinary income figured for each element.
The following are the types of separate elements.
-
A separate improvement (defined later).
-
The basic section 1250 property plus improvements
not qualifying as separate improvements.
-
The units placed in service at different times
before all the section 1250 property is finished. For
example, this happens when a taxpayer builds an
apartment building of 100 units and places 30 units in
service (available for renting) on January 4, 2003, 50
on July 18, 2003, and the remaining 20 on January 18,
2004. As a result, the apartment house consists of
three separate elements.
The 36-month test for separate
improvements. A separate improvement is
any improvement (qualifying under The 1-year test, below)
added to the capital account of the property, but only
if the total of the improvements during the 36-month
period ending on the last day of any tax year is more
than the greatest of the following amounts.
-
One-fourth of the adjusted basis of the property at
the start of the first day of the 36-month period, or
the first day of the holding period of the property,
whichever is later.
-
One-tenth of the unadjusted basis (adjusted basis
plus depreciation and amortization adjustments) of the
property at the start of the period determined in (1).
-
$5,000.
The 1-year test.
An addition to the capital account for any
tax year (including a short tax year) is treated as an
improvement only if the sum of all additions for the
year is more than the greater of $2,000 or 1% of the
unadjusted basis of the property. The unadjusted basis
is figured as of the start of that tax year or the
holding period of the property, whichever is later. In
applying the 36-month test, improvements in any one of
the 3 years are omitted entirely if the total
improvements in that year do not qualify under the
1-year test.
Example.
The unadjusted basis of a calendar year taxpayer's
property was $300,000 on January 1 of this year. During
the year, the taxpayer made improvements A, B, and C,
which cost $1,000, $600, and $700, respectively. The sum
of the improvements, $2,300, is less than 1% of the
unadjusted basis ($3,000), so the improvements do not
satisfy the 1-year test and are not treated as
improvements for the 36-month test. However, if
improvement C had cost $1,500, the sum of these
improvements would have been $3,100. Then, it would be
necessary to apply the 36-month test to figure if the
improvements must be treated as separate improvements.
Addition to the capital
account. Any addition to the
capital account made after the initial acquisition or
completion of the property by you or any person who held
the property during a period included in your holding
period is to be considered when figuring the total
amount of separate improvements.
The addition to the capital account
of depreciable real property is the gross addition not
reduced by amounts attributable to replaced property.
For example, if a roof with an adjusted basis of $20,000
is replaced by a new roof costing $50,000, the
improvement is the gross addition to the account,
$50,000, and not the net addition of $30,000. The
$20,000 adjusted basis of the old roof is no longer
reflected in the basis of the property. The status of an
addition to the capital account is not affected by
whether it is treated as a separate property for
determining depreciation deductions.
Whether an expense is treated as an
addition to the capital account may depend on the final
disposition of the entire property. If the expense item
property and the basic property are sold in two separate
transactions, the entire section 1250 property is
treated as consisting of two distinct properties.
Unadjusted basis.
In figuring the unadjusted basis as of a
certain date, include the actual cost of all previous
additions to the capital account plus those that did not
qualify as separate improvements. However, the cost of
components retired before that date is not included in
the unadjusted basis.
Holding period. Use the
following guidelines for figuring the applicable
percentage for property with two or more elements.
-
The holding period of a separate element placed in
service before the entire section 1250 property is
finished starts on the first day of the month that the
separate element is placed in service.
-
The holding period for each separate improvement
qualifying as a separate element starts on the day
after the improvement is acquired or, for improvements
constructed, reconstructed, or erected, the first day
of the month that the improvement is placed in
service.
-
The holding period for each improvement not
qualifying as a separate element takes the holding
period of the basic property.
If an improvement by itself does not
meet the 1-year test (greater of $2,000 or 1% of the
unadjusted basis), but it does qualify as a separate
improvement that is a separate element (when grouped
with other improvements made during the tax year),
determine the start of its holding period as follows.
Use the first day of a calendar month that is closest to
the middle of the tax year. If there are two first days
of a month that are equally close to the middle of the
year, use the earlier date.
Figuring ordinary income attributable
to each separate element. Figure
ordinary income attributable to each separate element as
follows.
Step 1. Divide the element's
additional depreciation after 1975 by the sum of all the
elements' additional depreciation after 1975 to
determine the percentage used in Step 2.
Step 2. Multiply the percentage
figured in Step 1 by the lesser of the additional
depreciation after 1975 for the entire property or the
gain from disposition of the entire property (the
difference between the fair market value or amount
realized and the adjusted basis).
Step 3. Multiply the result in Step 2
by the applicable percentage for the element.
Example.
You sold at a gain of $25,000 low-income housing
property subject to the ordinary income rules of section
1250. The property consisted of four elements (W, X, Y,
and Z).
Step 1. The additional depreciation for each element
is: W-$12,000; X-None; Y-$6,000; and Z-$6,000. The sum
of the additional depreciation for all the elements is
$24,000.
Step 2. The depreciation deducted on element X was
$4,000 less than it would have been under the straight
line method. Additional depreciation on the property as
a whole is $20,000 ($24,000 - $4,000). $20,000 is lower
than the $25,000 gain on the sale, so $20,000 is used in
Step 2.
Step 3. The applicable percentages to be used in Step
3 for the elements are: W-68%; X-85%; Y-92%; and Z-100%.
From these facts, the sum of the ordinary income for
each element is figured as follows.
| |
Step 1 |
Step 2 |
Step 3 |
Ordinary
Income |
| W..... |
.50 |
$10,000 |
68% |
$ 6,800 |
| X...... |
-0- |
-0- |
85% |
-0- |
| Y...... |
.25 |
5,000 |
92% |
4,600 |
| Z...... |
.25 |
5,000 |
100% |
5,000 |
Sum of ordinary
income
of separate elements |
$16,400 |
Gain Treated as
Ordinary Income
To find what part of the gain from the disposition of
section 1250 property is treated as ordinary income,
follow these steps.
-
In a sale, exchange, or involuntary conversion of
the property, figure the amount realized that is more
than the adjusted basis of the property. In any other
disposition of the property, figure the fair market
value that is more than the adjusted basis.
-
Figure the additional depreciation for the periods
after 1975.
-
Multiply the lesser of (1) or (2) by the applicable
percentage, discussed earlier. Stop here if this is
residential rental property or if (2) is equal to or
more than (1). This is the gain treated as ordinary
income because of additional depreciation.
-
Subtract (2) from (1).
-
Figure the additional depreciation for periods
after 1969 but before 1976.
-
Add the lesser of (4) or (5) to the result in (3).
This is the gain treated as ordinary income because of
additional depreciation.
A limit on the amount treated as ordinary income for
gain on like-kind exchanges and involuntary conversions
is explained later.
Use Part III, Form 4797, to figure the ordinary
income part of the gain.
Corporations.
Corporations, other than S corporations,
have an additional amount to recognize as ordinary
income on the sale or other disposition of section 1250
property. The additional amount treated as ordinary
income is 20% of the excess of the amount that would
have been ordinary income if the property were section
1245 property over the amount treated as ordinary income
under section 1250. Report this additional ordinary
income on Form 4797, Part III, line 26 (f).
If you report the sale of property under the
installment method, any depreciation recapture under
section 1245 or 1250 is taxable as ordinary income in
the year of sale. This applies even if no payments are
received in that year. If the gain is more than the
depreciation recapture income, report the rest of the
gain using the rules of the installment method. For this
purpose, include the recapture income in your
installment sale basis to determine your gross profit on
the installment sale.
If you dispose of more than one asset in a single
transaction, you must figure the gain on each asset
separately so that it may be properly reported. To do
this, allocate the selling price and the payments you
receive in the year of sale to each asset. Report any
depreciation recapture income in the year of sale before
using the installment method for any remaining gain.
For a detailed discussion of installment sales, see
Publication 537.
If you make a gift of depreciable personal property
or real property, you do not have to report income on
the transaction. However, if the person who receives it
(donee) sells or otherwise disposes of the property in a
disposition subject to recapture, the donee must take
into account the depreciation you deducted in figuring
the gain to be reported as ordinary income.
For low-income housing, the donee must take into
account the donor's holding period to figure the
applicable percentage. See Applicable Percentage and
its discussion Holding period
under Section 1250
Property, earlier.
Part gift and part sale or
exchange. If you transfer depreciable
personal property or real property for less than its
fair market value in a transaction considered to be
partly a gift and partly a sale or exchange and you have
a gain because the amount realized is more than your
adjusted basis, you must report ordinary income (up to
the amount of gain) to recapture depreciation. If the
depreciation (additional depreciation, if section 1250
property) is more than the gain, the balance is carried
over to the transferee to be taken into account on any
later disposition of the property. However, see Bargain sale to charity,
later.
Example.
You transferred depreciable personal property to your
son for $20,000. When transferred, the property had an
adjusted basis to you of $10,000 and a fair market value
of $40,000. You took depreciation of $30,000. You are
considered to have made a gift of $20,000, the
difference between the $40,000 fair market value and the
$20,000 sale price to your son. You have a taxable gain
on the transfer of $10,000 ($20,000 sale price minus
$10,000 adjusted basis) that must be reported as
ordinary income from depreciation. You report $10,000 of
your $30,000 depreciation as ordinary income on the
transfer of the property, so the remaining $20,000
depreciation is carried over to your son for him to take
into account on any later disposition of the property.
Gift to charitable organization. If you
give property to a charitable organization, you figure
your deduction for your charitable contribution by
reducing the fair market value of the property by the
ordinary income and short-term capital gain that would
have resulted had you sold the property at its fair
market value at the time of the contribution. Thus, your
deduction for depreciable real or personal property
given to a charitable organization does not include the
potential ordinary gain from depreciation.
You also may have to reduce the fair
market value of the contributed property by the
long-term capital gain (including any section 1231 gain)
that would have resulted had the property been sold. For
more information, see Giving
Property That Has Increased in Value in
Publication 526, Charitable Contributions.
Bargain sale to charity. If you transfer section
1245 or section 1250 property to a charitable
organization for less than its fair market value and a
deduction for the contribution part of the transfer is
allowable, your ordinary income from depreciation is
figured under different rules. First, figure the
ordinary income as if you had sold the property at its
fair market value. Then, allocate that amount between
the sale and the contribution parts of the transfer in
the same proportion that you allocated your adjusted
basis in the property to figure your gain. See Bargain Sale under Gain or Loss From Sales and Exchanges
in chapter 1. Report as ordinary income the
lesser of the ordinary income allocated to the sale or
your gain from the sale.
Example.
You sold section 1245 property in a bargain sale to a
charitable organization and are allowed a deduction for
your contribution. Your gain on the sale was $1,200,
figured by allocating 20% of your adjusted basis in the
property to the part sold. If you had sold the property
at its fair market value, your ordinary income would
have been $5,000. Your ordinary income is $1,000 ($5,000
x 20%) and your section 1231 gain is $200 ($1,200 -
$1,000).
When a taxpayer dies, no gain is reported on
depreciable personal property or real property
transferred to his or her estate or beneficiary. For
information on the tax liability of a decedent, see
Publication 559, Survivors, Executors, and
Administrators.
However, if the decedent disposed of the property
while alive and, because of his or her method of
accounting or for any other reason, the gain from the
disposition is reportable by the estate or beneficiary,
it must be reported in the same way the decedent would
have had to report it if he or she were still alive.
Ordinary income due to depreciation must be reported
on a transfer from an executor, administrator, or
trustee to an heir, beneficiary, or other individual if
the transfer is a sale or exchange on which gain is
realized.
Example 1.
Janet Smith owned depreciable property that, upon her
death, was inherited by her son. No ordinary income from
depreciation is reportable on the transfer, even though
the value used for estate tax purposes is more than the
adjusted basis of the property to Janet when she died.
However, if she sold the property before her death and
realized a gain and if, because of her method of
accounting, the proceeds from the sale are income in
respect of a decedent reportable by her son, he must
report ordinary income from depreciation.
Example 2.
The trustee of a trust created by a will transfers
depreciable property to a beneficiary in satisfaction of
a specific bequest of $10,000. If the property had a
value of $9,000 at the date used for estate tax
valuation purposes, the $1,000 increase in value to the
date of distribution is a gain realized by the trust.
Ordinary income from depreciation must be reported by
the trust on the transfer.
Like-Kind
Exchanges and Involuntary
Conversions
A like-kind exchange of your depreciable property or
an involuntary conversion of the property into similar
or related property will not result in your having to
report ordinary income from depreciation unless money or
property other than like-kind, similar, or related
property is also received in the transaction. For
information on like-kind exchanges and involuntary
conversions, see chapter 1.
Depreciable personal property.
If you have a gain from either a like-kind
exchange or an involuntary conversion of your
depreciable personal property, the amount to be reported
as ordinary income from depreciation is the amount
figured under the rules explained earlier (see Section 1245 Property),
limited to the sum of the following amounts.
-
The gain that must be included in income under the
rules for like-kind exchanges or involuntary
conversions.
-
The fair market value of the like-kind, similar, or
related property other than depreciable personal
property acquired in the transaction.
Example 1.
You bought a new machine for $4,300 cash plus your
old machine for which you were allowed a $1,360
trade-in. The old machine cost you $5,000 two years ago.
You took depreciation deductions of $3,950. Even though
you deducted depreciation of $3,950, the $310 gain
($1,360 trade-in allowance minus $1,050 adjusted basis)
is not reported because it is postponed under the rules
for like-kind exchanges and you received only
depreciable personal property in the exchange.
Example 2.
You bought office machinery for $1,500 two years ago
and deducted $780 depreciation. This year a fire
destroyed the machinery and you received $1,200 from
your fire insurance, realizing a gain of $480 ($1,200 -
$720 adjusted basis). You choose to postpone reporting
gain, but replacement machinery cost you only $1,000.
Your taxable gain under the rules for involuntary
conversions is limited to the remaining $200 insurance
payment. All your replacement property is depreciable
personal property, so your ordinary income from
depreciation is limited to $200.
Example 3.
A fire destroyed office machinery you bought for
$116,000. The depreciation deductions were $91,640 and
the machinery had an adjusted basis of $24,360. You
received a $117,000 insurance payment, realizing a gain
of $92,640.
You immediately spent $105,000 of the insurance
payment for replacement machinery and $9,000 for stock
that qualifies as replacement property and you choose to
postpone reporting the gain. $114,000 of the $117,000
insurance payment was used to buy replacement property,
so the gain that must be included in income under the
rules for involuntary conversions is the part not spent,
or $3,000. The part of the insurance payment ($9,000)
used to buy the nondepreciable property (the stock) also
must be included in figuring the gain from depreciation.
The amount you must report as ordinary income on the
transaction is $12,000, figured as follows.
If, instead of buying $9,000 in
stock, you bought $9,000 worth of depreciable personal
property similar or related in use to the destroyed
property, you would only report $3,000 as ordinary
income.
Depreciable real property. If you have a gain from
either a like-kind exchange or involuntary conversion of
your depreciable real property, ordinary income from
additional depreciation is figured under the rules
explained earlier (see Section
1250 Property), limited to the greater of
the following amounts.
-
The gain that must be reported under the rules for
like-kind exchanges or involuntary conversions plus
the fair market value of stock bought as replacement
property in acquiring control of a corporation.
-
The gain you would have had to report as ordinary
income from additional depreciation had the
transaction been a cash sale minus the cost (or fair
market value in an exchange) of the depreciable real
property acquired.
The ordinary income not reported for
the year of the disposition is carried over to the
depreciable real property acquired in the like-kind
exchange or involuntary conversion as additional
depreciation from the property disposed of. Further, to
figure the applicable percentage of additional
depreciation to be treated as ordinary income, the
holding period starts over for the new property.
Example.
The state paid you $116,000 when it condemned your
depreciable real property for public use. You bought
other real property similar in use to the property
condemned for $110,000 ($15,000 for depreciable real
property and $95,000 for land). You also bought stock
for $5,000 to get control of a corporation owning
property similar in use to the property condemned. You
choose to postpone reporting the gain. If the
transaction had been a sale for cash only, under the
rules described earlier, $20,000 would have been
reportable as ordinary income because of additional
depreciation.
The ordinary income to be reported is $6,000, which
is the greater of the following amounts.
-
The gain that must be reported under the rules for
involuntary conversions, $1,000 ($116,000 - $115,000)
plus the fair market value of stock bought as
qualified replacement property, $5,000, for a total of
$6,000.
-
The gain you would have had to report as ordinary
income from additional depreciation ($20,000) had this
transaction been a cash sale minus the cost of the
depreciable real property bought ($15,000), or $5,000.
The ordinary income not
reported, $14,000 ($20,000 - $6,000), is carried over to
the depreciable real property you bought as additional
depreciation.
Basis of property acquired.
If the ordinary income you have to report
because of additional depreciation is limited, the total
basis of the property you acquired is its fair market
value (its cost, if bought to replace property
involuntarily converted into money) minus the gain
postponed.
If you acquired more than one item of
property, allocate the total basis among the properties
in proportion to their fair market value (their cost, in
an involuntary conversion into money). However, if you
acquired both depreciable real property and other
property, allocate the total basis as follows.
-
Subtract the ordinary income because of additional
depreciation that you do not have to report from the
fair market value (or cost) of the depreciable real
property acquired.
-
Add the fair market value (or cost) of the other
property acquired to the result in (1).
-
Divide the result in (1) by the result in (2).
-
Multiply the total basis by the result in (3). This
is the basis of the depreciable real property
acquired. If you acquired more than one item of
depreciable real property, allocate this basis amount
among the properties in proportion to their fair
market value (or cost).
-
Subtract the result in (4) from the total basis.
This is the basis of the other property acquired. If
you acquired more than one item of other property,
allocate this basis amount among the properties in
proportion to their fair market value (or cost).
Example 1.
In 1986, low-income housing property that you
acquired and placed in service in 1981 was destroyed by
fire and you received a $90,000 insurance payment. The
property's adjusted basis was $38,400, with additional
depreciation of $14,932. On December 1, 1986, you used
the insurance payment to acquire and place in service
replacement low-income housing property.
Your realized gain from the involuntary conversion
was $51,600 ($90,000 - $38,400). You chose to postpone
reporting the gain under the involuntary conversion
rules. Under the rules for depreciation recapture on
real property, the ordinary gain was $14,932, but you
did not have to report any of it because of the limit
for involuntary conversions.
The basis of the replacement low-income housing
property was its $90,000 cost minus the $51,600 gain you
postponed, or $38,400. The $14,932 ordinary gain you did
not report is treated as additional depreciation on the
replacement property. When you dispose of the property,
your holding period for figuring the applicable
percentage of additional depreciation to report as
ordinary income will have begun December 2, 1986, the
day after you acquired the property.
Example 2.
John Adams received a $90,000 fire insurance payment
for depreciable real property (office building) with an
adjusted basis of $30,000. He uses the whole payment to
buy property similar in use, spending $42,000 for
depreciable real property and $48,000 for land. He
chooses to postpone reporting the $60,000 gain realized
on the involuntary conversion. Of this gain, $10,000 is
ordinary income from additional depreciation but is not
reported because of the limit for involuntary
conversions of depreciable real property. The basis of
the property bought is $30,000 ($90,000 - $60,000),
allocated as follows.
-
The $42,000 cost of depreciable real property minus
$10,000 ordinary income not reported is $32,000.
-
The $48,000 cost of other property (land) plus the
$32,000 figured in (1) is $80,000.
-
The $32,000 figured in (1) divided by the $80,000
figured in (2) is 0.4.
-
The basis of the depreciable real property is
$12,000. This is the $30,000 total basis multiplied by
the 0.4 figured in (3).
-
The basis of the other property (land) is $18,000.
This is the $30,000 total basis minus the $12,000
figured in (4).
The ordinary income that is not reported ($10,000) is
carried over as additional depreciation to the
depreciable real property that was bought and may be
taxed as ordinary income on a later disposition.
If you dispose of both depreciable property and other
property in one transaction and realize a gain, you must
allocate the amount realized between the two types of
property in proportion to their respective fair market
values to figure the part of your gain to be reported as
ordinary income from depreciation. Different rules may
apply to the allocation of the amount realized on the
sale of a business that includes a group of assets. See
chapter 2.
In general, if a buyer and seller have adverse
interests as to the allocation of the amount realized
between the depreciable property and other property, any
arm's-length agreement between them will establish the
allocation.
In the absence of an agreement, the allocation should
be made by taking into account the appropriate facts and
circumstances. These include, but are not limited to, a
comparison between the depreciable property and all the
other property being disposed of in the transaction. The
comparison should take into account all the following
facts and circumstances.
-
The original cost and reproduction cost of
construction, erection, or production.
-
The remaining economic useful life.
-
The state of obsolescence.
-
The anticipated expenditures required to maintain,
renovate, or modernize the properties.
Like-kind exchanges and involuntary
conversions. If you dispose of and
acquire both depreciable personal property and other
property (other than depreciable real property) in a
like-kind exchange or involuntary conversion, the amount
realized is allocated in the following way. The amount
allocated to the depreciable personal property disposed
of is treated as consisting of, first, the fair market
value of the depreciable personal property acquired and,
second (to the extent of any remaining balance), the
fair market value of the other property acquired. The
amount allocated to the other property disposed of is
treated as consisting of the fair market value of all
property acquired that has not already been taken into
account.
If you dispose of and acquire
depreciable real property and other property in a
like-kind exchange or involuntary conversion, the amount
realized is allocated in the following way. The amount
allocated to each of the three types of property
(depreciable real property, depreciable personal
property, or other property) disposed of is treated as
consisting of, first, the fair market value of that type
of property acquired and, second (to the extent of any
remaining balance), any excess fair market value of the
other types of property acquired. If the excess fair
market value is more than the remaining balance of the
amount realized and is from both of the other two types
of property, you can apply the unallocated amount in any
manner you choose.
Example.
A fire destroyed your property with a total fair
market value of $50,000. It consisted of machinery worth
$30,000 and nondepreciable property worth $20,000. You
received an insurance payment of $40,000 and immediately
used it with $10,000 of your own funds (for a total of
$50,000) to buy machinery with a fair market value of
$15,000 and nondepreciable property with a fair market
value of $35,000. The adjusted basis of the destroyed
machinery was $5,000 and your depreciation on it was
$35,000. You choose to postpone reporting your gain from
the involuntary conversion. You must report $9,000 as
ordinary income from depreciation arising from this
transaction, figured as follows.
-
The $40,000 insurance payment must be allocated
between the machinery and the other property destroyed
in proportion to the fair market value of each. The
amount allocated to the machinery is 30,000/50,000 x
$40,000, or $24,000. The amount allocated to the other
property is 20,000/50,000 x $40,000, or $16,000. Your
gain on the involuntary conversion of the machinery is
$24,000 minus $5,000 adjusted basis, or $19,000.
-
The $24,000 allocated to the machinery disposed of
is treated as consisting of the $15,000 fair market
value of the replacement machinery bought and $9,000
of the fair market value of other property bought in
the transaction. All $16,000 allocated to the other
property disposed of is treated as consisting of the
fair market value of the other property that was
bought.
-
Your potential ordinary income from depreciation is
$19,000, the gain on the machinery, because it is less
than the $35,000 depreciation. However, the amount you
must report as ordinary income is limited to the
$9,000 included in the amount realized for the
machinery that represents the fair market value of
property other than the depreciable property you
bought.
|
