Understanding Depreciation Recapture Income Tax Liability
Investors are liable for depreciation taken that has not been offset by corresponding capital improvements in the property; however, determining recapture income tax liability on the sale of investment property is one of the most complex tax liabilities facing any Investor in real estate.
Section 1245 of the Internal Revenue Service code is comprised of all property personally owned by the Investor, in addition to specific types of real property subject to an allowance for depreciation, amortization, or special first-year expensing, although this typically applies to property that depreciable in nature. The Investor may determine depreciation limitation for property by adding the relevant deductions taken with respect to any item of Section 1245 property; given the nature of most Section 1245 property, the likelihood of an increase in value above original cost is minor, although it is important for an Investor to be aware that the depreciation limitation does have bearing on determining recapture liability. Depreciation is calculated with the deductions for but not limited to exhaustion, wear and tear, obsolescence or amortization.
The cost basis of the Investor’s property must be reduced by the amount of depreciation or amortization allowed the Investor; if greater, the basis in the property is reduced by the depreciation the taxpayer could have elected to take even if the taxpayer in fact did not actually claim the depreciation deduction. The amount allowable will be used to compute the taxpayer’s overall of gain on the sale of the property, despite the fact that the amount of depreciation allowable may not be subject to recapture. Property contained in and/or attached to a building and assets in the nature of machinery is known as "tangible personal property." Land and improvements do not count in this category. All property contained in or attached to a building except structural components are typically depreciable under Section 1245; this is a large category, and can include a wide variety of property.
Real property may be subject to recapture under Section 1245 or Section 1250, and personal property is subject to recapture only under Section 1245. Property initially characterized as either Sec. 1245 property will remain characterized as such for the life of the property; property originally classified as Section 1250 property may be recharacterized as Section 1245 property and be treated as if it had always been Section 1245 property. All personal property, regardless of type, is subject to depreciation recapture under Section 1245. Also, certain properties considered to be real property under Section 1250 under local law may nonetheless be characterized as personal property depreciable under Sec. 1245 for federal tax purposes.
There are two intangible types of personal property that are depreciable under Section 1245, in addition to standard tangible personal property assets:
- Intangible property pursuant to Section 197
- Intangible personal property subject to an allowance for depreciation
Starting from the month the taxpayer initially acquires the property, Section 197 intangibles may be amortized over a fifteen year period and constitutes property subject to depreciation recapture under Section 1245. Intangible personal property subject to the allowance for depreciation also constitutes Section 1245 property.
Section 1245 applies only to property which is or has been property of a character subject to the allowance for depreciation under Section 167, but a leasehold interest in Section 1245 property is also Section 1245 property. This does not extend however to leasehold interests in real property, but these interests are not subject to depreciation recapture pursuant to Section 1245 and the determination of whether the leasehold interest falls under Section 1245 is based on the nature of the underlying property.
Accelerate Cost Recovery System (ACRS) are recovery deductions for most depreciable property and can figure into the calculation of depreciation recapture; recovery deductions taken under ACRS generally are subject to recapture in a manner similar to depreciation deductions, and properties subject to recovery deductions under ACRS are not always classified in a manner consistent with similar properties. All ACRS real property is subject to recapture under Section 1245 except for:
- Residential rental property
- Property used "predominantly" outside the United States
- Property as to which an election to use straight-line recovery is in effect
- Certain low-income and federally insured residential property
Section 1250 property includes all real property subject to the allowance for depreciation and the four types of ACRS 19 year properties, except for Section 1245 property. Land is not depreciable and therefore not subject to recapture under Section 1250. Recapture under Section 1250 is really only applicable to the permanent structures/improvements made to the land, and buildings are considered to be “improvements” of property regardless of their usage; if the structure's function is to provide a controlled environment and space for the performance of indoor work, and if it is equally important to provide work space and a controlled environment, then the structure is appropriately characterized as a building. This also applies to some tangible real property that falls outside the standard definition of a building or structural component of a building, but is a permanent structure.
An investor will need to calculate the gain on sale, exchange, or involuntary conversion, or the "potential gain" in the case of any other disposition attributable to that property in order to tell if the amount of gain subject to recapture and treated as ordinary income on a disposition of property that triggers Section 1245 or Section 1250; the amount of gain treated as ordinary income under that section is either the gain limitation or the depreciation limitation, whichever is less. The amount realized when Section 1245 and non-Section 1245 property are disposed of in the same transaction is allocated to both types of property in proportion to their respective market values; the amount subject to recapture cannot exceed the gain realized or the potential gain.
Depreciation recaptured as ordinary income cannot exceed the gain realized; the gain limitation is the amount by which that value exceeds the adjusted basis of the property given up in the exchange, and the amount realized equals the fair market value of the property received in the exchange. The Investor is not responsible for paying any depreciation recapture due at the time, but the adjusted basis of the replacement property or properties will be lowered. The amount of gain recaptured and treated as ordinary income under those sections cannot exceed either the gain or depreciation limitations.
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