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:
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Section 1231 gains and losses
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Depreciation recapture
Useful Items -
You may want to see:
Publication
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534 Depreciating Property Placed in Service
Before 1987
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537 Installment Sales
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551 Basis of Assets
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946 How To Depreciate Property
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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.
Caution
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.
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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).
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Sales or exchanges of leaseholds. The leasehold
must be used in a trade or business and held longer than 1 year.
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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.
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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.
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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.
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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.
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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.
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If you have a net section 1231 loss, it is ordinary
loss.
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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.
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Whether the adjusted basis was figured using depreciation
or amortization you claimed on other property.
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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.
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Personal property (either tangible or intangible).
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Other tangible property (except buildings and their
structural components) used as any of the following.
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An integral part of manufacturing, production,
or extraction, or of furnishing transportation, communications, electricity, gas,
water, or sewage disposal services.
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A research facility in any of the activities in
(a).
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A facility in any of the activities in (a) for
the bulk storage of fungible commodities.
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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.
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Single purpose agricultural (livestock) or horticultural
structures.
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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.
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The depreciation and amortization allowed or allowable
on the property.
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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.
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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.
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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.
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Ordinary depreciation deductions.
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The 30% special depreciation allowance for property
acquired after September 10, 2001.
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The 50% special depreciation allowance for property
acquired after May 5, 2003.
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Amortization deductions for all the following costs.
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Acquiring a lease.
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Lessee improvements.
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Pollution control facilities.
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Reforestation expenses.
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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.
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The section 179 deduction.
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Deductions for all the following costs.
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Removing barriers to the disabled and the elderly.
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Tertiary injectant expenses.
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Depreciable clean-fuel vehicles and refueling property
(minus the amount of any recaptured deduction).
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Environmental cleanup costs.
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Any basis reduction for the investment credit (minus
any basis increase for credit recapture).
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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.
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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.
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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.
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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.
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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.
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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.
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Low-income rental housing for which a depreciation
deduction for rehabilitation expenses was allowed.
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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.
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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.
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A separate improvement (defined later).
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The basic section 1250 property plus improvements
not qualifying as separate improvements.
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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.
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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.
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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).
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$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 |
