The ins and outs of recapture.

Tax advisers can help clients avoid, shift or postpone depreciation recapture on property used in a trade or business. Part II of this article discusses special recapture rules and exceptions and planning strategies for minimizing recapture.

The depreciation recapture provisions are complicated and pervasive, significantly affecting the tax on many sales, exchanges and other dispositions. However, in many cases, recapture can be reduced, delayed or even eliminated. In the July 2005 issue, Part I of this two-part article explained how the recapture provisions operate and offered examples of recapture calculations. Part II, below, discusses special recapture rules and exceptions, and suggests planning techniques.

Special Recapture Rules

For installment sales, nontaxable exchanges, charitable contributions or gifts and inheritances, the Code provides special rules when applying Sec. 1245's and 1250's recapture provisions.

Installment Sales

Sec. 453(i)(1) was amended in 1984 to provide that all depreciation recapture income on an installment sale after June 6, 1984 has to be recognized in the year of sale, regardless of the payment (if any) received in that year. The recognized recapture income increases the property's adjusted basis when calculating the gross profit percentage (GPP) applied to the actual payments received.

Example 1: G sells a depreciable machine (with an $80,000 original cost and a $40,000 basis) for $100,000, payable in five $20,000 installments beginning in 2005. Normally, in an installment sale, G would compute a GPP of 60% ($60,000 gain/$100,000 total contract price), and recognize $12,000 gain ($60,000 x 0.20) in each of the five years. However, under Sec. 453(i), G reports the entire $40,000 depreciation recapture as gain in the sale year. This decreases his GPP to 20% ($20,000/ $100,000); he would report an additional $4,000 Sec. 1231 gain for 2005 and the succeeding four years.

Nontaxable Exchanges

A taxpayer can defer realized gain on certain nontaxable exchanges and involuntary conversions. However, if boot is received, or if involuntary conversion proceeds received are not reinvested in qualifying replacement property, (8) the taxpayer must recognize gain, which is subject to depreciation recapture. (9) According to Regs. Sec. 1.1245-2(c)(2), any remaining recapture potential carries over to the property received in the exchange. Examples of these transfers include contributions to corporations or partnerships under Sec. 351 or 721, like-kind exchanges under Sec. 1031, Sec. 1033 involuntary conversions, Sec. 361 tax-free corporate reorganizations and Sec. 332 liquidations of subsidiaries.

Example 2: H exchanges an old business machine with a $3,000 adjusted basis for a new machine worth $4,000, and $500. The old machine had cost $4,800 six years ago.

Under Sec. 1031, H recognizes $500 gain on the exchange (equal to the boot received). All of it must be reported as ordinary income under Sec. 1245, because a sale of the old machine at its fair market value (FMV) of $4,500 (the value received) would have generated $1,500 Sec. 1245 income, which is less than the $1,800 total depredation allowed in prior years.

Charitable Contributions

Contributions of Sec. 1245 or 1250 properties to recognized charities are contributions of "ordinary income property" when applying the Sec. 170 limits on property contributions. Under Sec. 170(e)(1)(A) and Regs. Sec. 1.170A-4(b)(1), the charitable deduction is reduced by the ordinary income that would have been recognized had the donated asset been sold. This reduction applies only for contributions of long-term appreciated assets on which depredation has been claimed.

Example 3: R, an individual, donates a residential apartment building to a recognized charity when the building has a $60,000 adjusted basis and a $72,000 FMV. R had taken depreciation deductions in excess of straight-line of $7,000 during the five years she owned the building. R's charitable deduction is $65,000 ($72,000 FMV--$7,000 Sec. 1250 recapture potential).

Gifts and Inheritances

The recapture provisions of Secs. 1245 and 1250 do not apply to gifts of appreciated assets. (10) Instead, the recapture potential carries over to the donee. (11) If the donee later disposes of the property, he or she must compute depreciation recapture, including any carryover amount. (12) This recapture taint remains, even if the donee converts the property to personal use.

Example 4: The facts are the same as in Example 2. In the exchange, H recognized $500 ordinary income under Sec. 1245. However, the recapture potential from selling the business machine, rather than having exchanged it, would have been $1,500. Thus, H carries over $1,000 of this recapture potential to the new machine. If H later sells or exchanges the new machine, he will have to report, at a minimum, the first $1,000 of recognized gain as ordinary income.

Inherited property is treated somewhat differently. Like gifts, transfers of appreciated property at death do not invoke Sec. 1245 or 1250. (13) In contrast to the treatment of gifts, there is no carryover of depredation recapture to the transferee.

Other Recapture Provisions

Sec. 1239

Under Sec. 1239, gain realized on a sale of depreciable property to a related party must be reported as ordinary income. Under Sec. 1239(a), the sale or exchange may be direct or indirect. For purposes of applying this rule, related taxpayers include (1) a taxpayer and a trust in which the taxpayer (or spouse) is a beneficiary; (2) a taxpayer and a corporation or partnership more than 50% owned by the taxpayer; (3) corporations that are members of the same "controlled group" (a parent-subsidiary controlled group includes a parent and one or more chains of subsidiaries connected by more than 50% intercorporate ownership; a brother-sister controlled group includes two or more corporations owned more than 50% by the same five or fewer persons); and (4) a corporation and a partnership owned more than 50% by the same persons.

In determining whether the "more than 50% ownership" tests are met, attribution rules found in Sec. 267(c) (with the exception of Sec. 267(c)(3)) apply. Thus, a taxpayer is deemed to own stock owned by members of his or her family, as well as a pro-rata portion of any stock owned by (1) a corporation in which the taxpayer is a shareholder or (2) an estate, a trust or a partnership in which the taxpayer is a beneficiary or partner.

Example 5: M sells a plating machine to O Corp. for $60,000. The machine had originally cost $50,000, and $2,000 depreciation had been taken. Thus, M's realized gain is $12,000. Of the outstanding shares of O stock, M owns 40%, M'S spouse owns 30%, and M's daughter and cousin each own 15%. In applying Sec. 1239, M is deemed to own 85% of the O shares; only the cousin's shares are not covered by the constructive ownership rules. Thus, M reports the entire $12,000 gain as ordinary income. Unlike Sec. 1245, the ordinary gain is not limited to total depreciation taken.

Secs. 179 and 280F

Currently, taxpayers may elect to expense up to $100,000 of the cost of tangible business personality under Sec. 179 (indexed for inflation, for tax years beginning after 2002 and before 2008; otherwise limited to $25,000). The $100,000 expense limit for any tax year is reduced (but not below zero) by the amount by which the cost of Sec. 179 property placed in service during such year exceeds $400,000 ($200,000 for tax years beginning before 2003 and after 2007). The $100,000 expense limit is further restricted to the aggregate amount of taxable income for the tax year. These limits apply to a partnership or S corporation and to each partner or shareholder. Basis for Sec. 179 purposes is determined on an asset-by-asset basis, without regard to the basis of other property held at any time.

If Sec. 179 property is later converted to nonbusiness use, part of the Sec. 179 deduction is recaptured as ordinary income. (14) The amount recaptured is the difference between the Sec. 179 deduction and the amount that otherwise would have been claimed as depreciation. Likewise, Sec. 280F recaptures as ordinary income the excess of accelerated deprecation over straight-line on personality that is listed property if business use falls to 50% or less in any year. (15)

See. 1231(c)'s "Look-Back" Rule

When Congress enacted the Sec. 1231 provisions, it inadvertently encouraged taxpayers to "load up" Sec. 1231 gains and losses in different tax years. If a tax year had only Sec. 1231 gains, they were taxed as long-term capital gains; if the tax year had only losses, such losses were deductible as ordinary losses. Reporting both gains and losses in the same tax year would simply cancel out the beneficial tax effects. To prevent such selective dispositions, Congress enacted a special Sec. 1231(c) recapture rule, under which any net Sec. 1231 gain reportable in a tax year has to be "recaptured" as ordinary income to the extent of any "unrecaptured" net Sec. 1231 losses in the preceding five years. A past Sea 1231 loss is applied only once in recapturing net Sec. 1231 gain.

Example 6: S's 2005 Sec. 1231 transactions netted to a $24,000 gain. S had reported a net Sec. 1231 loss of $16,000 in 2002 and a net Sec. 1231 gain of $5,000 in 2003.

For 2005, S reports $11,000 of the $24,000 gain as ordinary income, as $11,000 of the 2002 net $16,000 Sec. 1231 loss was not recaptured as of 2005 ($5,000 would have been recaptured in 2003). S reports the remaining $13,000 2005 gain as Sec. 1231 gain; because there are no other Sec. 1231 transactions, S reports it as long-term capital gain.

Planning Considerations

While the depreciation recapture provisions have an unusually far-reaching effect on dispositions of depreciable property, taxpayers can minimize it. The discussion below explains how to properly view recapture and how to avoid or delay it, or shill it to other taxpayers.

A Proper Perspective

Depreciation recapture is not quite as draconian as it is sometimes portrayed. In most cases, the worst result is that a taxpayer has received an interest-free loan from the government (i.e., has swapped current deductions for future potential gains taxed at the same rate). This view changes somewhat if the taxpayer is in a high tax bracket when the asset is disposed of, or has engaged in an installment sale. Otherwise, tax savings from current deductions are available to invest until repaid at disposition (assuming such disposition results in taxable gain).

Sec. 1250 Recapture Is Disappearing

Sec. 1250 recapture will soon be extinct. Because it applies only to properties placed in service before 1987, and because such properties had a maximum modified accelerated cost recovery system (MACRS) recovery period of 19 years, they will all be fully depreciated by 2007. Of course, when such assets are fully depreciated, there is no "excess depreciation" and, hence, no Sec. 1250 gain. Even before 2007, the excess depreciation Hill be miniscule in most cases. Further, realty placed in service prior to 1981 is now at least 25 years old, and well into the reversal of excess depreciation caused by straight-line deductions exceeding accelerated ones. This does not apply to Sec. 1250 properties or nonresidential realty placed in service under ACRS and subject to accelerated cost recovery. In either case, recapture is expressed as a percentage of total depredation taken, not just "excess depreciation."

Avoiding Recapture

Avoiding depreciation recapture is difficult; however, sometimes, taxpayers can avoid Sec. 1250 recapture by holding property for a specified period. For example, this would apply to realty on which accelerated depreciation was taken if the property was placed in service before 1981 (or residential realty was placed in service from 1981 to 1986) and held until fully depreciated. In such case, there is no excess deprecation to be recaptured under Sec. 1250. However, in situations to which Sec. 1250 no longer applies, there is still Sec. 291 for corporations and the 25% gain rate on individual unrecaptured Sec. 1250 gain.

One other way for an individual to avoid both Secs. 1245 and 1250 is to transfer depreciable assets at death. Under Secs. 1245(b)(2) and 1250(d)(2), a beneficiary receives the asset (1) free of any depreciation recapture carryover and (2) with a stepped-up basis.

Delaying or Minimizing Recapture

A taxpayer can postpone depreciation recapture by using a nontaxable exchange to dispose of an appreciated asset. For example, by transferring a depreciable asset in a like-kind exchange, the taxpayer avoids immediate depreciation recapture, unless boot is received. However, the recapture potential will be carried over to the replacement property received.

A taxpayer may also minimize the effect of depreciation recapture's ordinary income recognition by planning to dispose of assets in low-tax-bracket years. Alternatively, if the taxpayer has net operating loss carryovers, recognizing ordinary income can help absorb these losses. Finally, taxpayers should be aware that Sec. 1231(c)'s recapture rule does not work in reverse. Thus, given a choice at the end of a year with no Sec. 1231 transactions and contemplating both gain and loss sales under Sec. 1231, a taxpayer should sell the gain property in the current year and the loss property in the next. However, the taxpayer should be aware that the loss sale would start the five-year clock running for any future net Sec. 1231 gains.

Shifting Recapture

Taxpayers can use other nontaxable exchanges to shift depreciation recapture to other taxpayers. For example, under Sec. 351, a taxpayer's transfer of depreciable property to a controlled corporation moves the recapture potential to the corporation. The same result is obtained with transfers to a partnership under Sec. 721.

If a taxpayer makes a bona fide gift of a depreciable asset to another person, the recapture provisions will not be triggered. However, the recapture potential stays with the property and will affect the donee on any subsequent disposition of the asset.

AMT 

In recent years, Congress has narrowed the differences between cost recovery deductions for regular tax purposes and for alternative minimum tax (AMT) purposes. For example, the Sec. 179 deduction and 30% or 50% bonus depreciation deductions allowed for regular tax purposes are also allowed for AMT purposes. Similarly, the MACRS life for assets placed in service after 1998 is also used for AMT purposes, although the recovery rate is reduced to 150% declining balance for the first four classes of personality. For these reasons, using an accelerated recovery method (when allowed) generally does not create an AMT problem; this should not be viewed as an another deterrent to possible additional recapture when considering the cost recovery method.

Installment Sales

If a taxpayer sells depreciable property on an installment basis, knowledge of the special Sec. 453(i) recapture rule discussed earlier is extremely important. For example, if the taxpayer sells depreciable personality for less than its original cost, the entire gain will be taxed in the year of sale, because the gain is less than total depreciation taken. In this situation, it may make sense to simply forgo the installment sale.

Even if some Sec. 1231 gain is generated and is eligible for installment reporting, a taxpayer may want to consider increasing the downpayment to cover the additional taxes in the year of sale. This might be done at little tax cost, because the recomputed GPP (after reflecting recapture recognition) will be lower.

Example 7: In Example 1 above, G had to recognize $40,000 of Sec. 1245 recapture income in the sale year, which reduced his GPP from 60% to 20%. Thus, if G is in the 31% tax bracket, G could require a $10,000 increase in the downpayment at a tax cost of only $620 ($10,000 x 0.20 x 0.31).

In some cases, the acceleration of recapture income on an installment sale might actually work to the taxpayer's advantage if the taxpayer were otherwise subject to the AMT in the installment sale year. As long as the taxpayer remains subject to the AMT, the additional ordinary income will be taxed at a maximum rate of 28% (individuals) (16) or 20% (corporations). (17) This contrasts with potential maximum ordinary income rates of 35% for individuals and 34% or 35% for corporations (39% for taxable income between $100,000 and $335,000). However, accelerating the income also generates a minimum tax credit to use in future years when regular tax liability exceeds the tentative minimum tax; in a sense, the net result may be that the taxpayer is merely accelerating the tax payment by one year. Thus, this strategy may make sense only for taxpayers in a more or less permanent AMT environment, or at least for those subject to the AMT for the next few years.

Conclusion

The depreciation recapture provisions are among the Code's most pervasive and complicated areas. Taxpayers using depreciable assets in a business should acquire an understanding of how the rules operate. With proper planning, tax advisers can help clients to reduce, shift, postpone or even avoid recapture.

(8) See Sec. 1245(b)(4) and Regs. Sec. 1.1245-4(d)(1); and Sec. 1250(d)(4) and Regs. Sec. 1.1250-3(d).

(9) See Secs. 1245(b)(3) and 1250(d)(3) and Regs. Secs. 1. 1245-4(c) and 1. 1250-3(c).

(10) See Secs. 1245(b)(1) and 1250(d)(1) and Kegs. Secs. 1.1245-4(a)(1) and 1.1250-3(a)(1).

(11) See Kegs. Secs. 1. 1245-2(a)(4) and 1. 12502(d)(3).

(12) See Regs. Secs. 1. 1245-2(c)(2) and 1. 12502(e)(2).

(13) See Secs. 1245(b)(2) and 1250(d)(2).

(14) See Sec. 179(d)(10) and Regs. Sec. 1.179-1(e).

(15) See Sec. 280F(b)(2)(A).

(16) See Sec. 55(b)(1)(A)(i)

(17) See Sec. 55(b)(1)(B)(i)

John O. Everett, Ph. D., CPA Professor of Accounting Virginia Commonwealth University Richmond, VA

Debra M. Grace, Ph. D., CPA Professor of Accountancy California State University Long Beach, CA