[Ed note: Burgeoning WS+B tax guru Scott Pintabone stops by to provide this weeks tax season lesson. Scott tackles three related code sections that all tax advisers are aware of, but few fully understand. What follows is an excellent primer to keep close to your desk during the remaining six weeks. Now, on to Scott:]
The number 1245 doesn’t just signify retired NFL running back Ricky Williams’ total rushing yards in 2001, three years before he decided to live the American dream and turn down millions of dollars, move to Africa, grow a raging beard and smoke enough marijuana to kill an army of Seth Rogens. It’s also a very important but oft-misunderstood Code section relating to the sale of business property, along with Sections 1231 and 1250. When disposing of an asset, these provisions are vital to determining the character of the gain or loss on the disposition.
So called “Section 1231 assets” are afforded the best of both worlds when disposed of: Section1231(a)(1) provides that a gain is treated as a long-term capital gain[i], while Section 1231(a)(2) provides that a loss is treated as an ordinary loss. Section 1231 assets are assets used in a trade or business, which are subject to depreciation and held for more than one year, or real property used in a trade or business that is held for greater than one year. Seems pretty simple right? Now the confusion…
When a taxpayer sells Section 1231 property for a gain, if within the last five years the taxpayer recognized Section 1231 losses, they may have to treat the gain as ordinary income. It’s a logical result, because since the taxpayer got the benefit of an ordinary loss in the previous year, he should have to “recapture” any previous ordinary losses as ordinary income prior to getting the capital gain treatment normally afforded Section 1231 gains.
To illustrate: if Taxpayer A sells Asset B recognizing an ordinary $30,000 Section 1231 loss in 2009 and then subsequently sells Asset C recognizing a $20,000 Section 1231 gain in 2011, the 2011 gain is characterized as ordinary income to the extent of the non-recaptured Section 1231 loss from 2009, or $20,000. Alternatively, if the 2011 gain were $40,000, the taxpayer would recognize ordinary income of $30,000 (the amount of the ordinary Section 1231 loss from 2009) and $10,000 of long-term capital gain, provided Sections 1245 or 1250 doesn’t apply (see below).
Section 1245 comes into play when you sell Section 1231 property (other than real property, which is covered in Section 1250) for a gain. In the simplest terms, Section 1245 requires that a taxpayer characterize the gain on the sale of 1231 property as ordinary income to the extent of any prior depreciation taken on the property.
For example, Taxpayer A purchases Asset B (equipment used in its trade or business) for $50,000 in 2009. Between 2009 and 2011, the taxpayer depreciated the asset by $20,000. In 2011, the taxpayer sells the asset for $40,000, recognizing a gain of $10,000 ($40,000 sale price less the adjusted basis of $30,000). This gain first must be considered under Section 1231. The taxpayer used the property in their trade or business, it is depreciable and was held for greater than one year therefore meeting the definition of Section 1231 property. Section 1245 trumps Section 1231 to convert any gain attributable to prior depreciation into ordinary income, however; because the gain is entirely a result of $20,000 of depreciation taken in prior years as an ordinary deduction, Section 1245 requires that the entire $10,000 gain be classified as ordinary income.
Alternatively, if the asset were sold for $60,000 resulting in a $30,000 gain, the taxpayer would recognize gain under Section 1245 of $20,000 (amount of prior depreciation taken) and a Section 1231 gain of $10,000 ($30,000 total gain less the Section 1245 gain of $20,000), which would be treated as capital gain.
Section 1250 is very similar to Section 1245 but deals with real property. Section 1250 requires that a gain on the sale of real property be treated as ordinary income to the extent of any accelerated depreciation in excess of straight-line that was previously taken on the property. Because most real property is depreciated under the straight-line method under current law, ordinary income recapture under Section 1250 is rare.
Even when there is no ordinary income recapture, however, Section 1(h) requires that all prior depreciation taken on a Section 1250 asset be taxed at a 25% rate as opposed to the typical 15% long-term capital gain. This is often referred to as “unrecaptured Section 1250 gain.”
To illustrate: A sells Asset X, a building used in A’s trade or business. X was originally purchased for $1,000,000 and was previously depreciated under the straight-line method to the tune of $200,000. A sells the building for $1,300,000, resulting in a $500,000 Section 1231 gain. Section 1250 (like Section 1245) trumps Section 1231, however, and requires any prior accelerated depreciation in excess of straight-line to be recaptured as ordinary income.
Because X was depreciated on a straight-line basis, there is no excess depreciation and thus no ordinary income recapture. To the extent of the prior straight-line depreciation, Section 1(h) requires A to tax the gain on the sale of X at 25%, rather than 15%. Thus, the $500,000 gain resulting from the sale of Asset X is bifurcated: $200,000 of the gain is taxed at 25%, with the remaining $300,000 taxed as Section 1231 gain eligible for a 15% rate.
As you can see, the disposition of business property can be pretty confusing. Hopefully the summary above helps clarify the application of the different code sections when dealing with the sale of property used in a trade or business.