Chapter 17A – Depreciation Recapture (Sections 1245 & 1250)

Context & Scope

• Lecture concerns awareness-level coverage (no in-class calculation work required) of depreciation recapture rules found in Chapter 17A of course material.
• Applies when preparing client tax returns that include the sale of business or rental property.
• Key Internal Revenue Code (IRC) provisions: Section 1231, Section 1245, Section 1250.
• Emphasis: how gains are split between ordinary income (due to prior depreciation deductions) and long-term capital gain (LTCG).

Section 1231 Assets – Quick Refresher

• Definition: property used in a trade or business and subject to depreciation (or real property used in a trade/business) held > 1 year.
• Typical examples
  • Business vehicles, machinery, computers (personal property)
  • Rental real estate, commercial buildings (real property)
• Tax outcomes when asset is sold:
  • Gain → potential LTCG (favorable rates) after recapture rules applied.
  • Loss → ordinary loss, fully deductible FOR AGI (offsets other income, not subject to 3{,}000 cap on capital losses).

Depreciation Recapture – Conceptual Overview

• When depreciation is claimed, taxpayer receives an ordinary-rate tax benefit.
• On disposition, the IRC requires taxpayers to “recapture” (re-tax at ordinary rates) the portion of gain attributable to previously allowed depreciation.
• Two separate regimes:
  1. Section 1245 – applies to tangible personal property (and certain intangibles).
  2. Section 1250 – applies to depreciable real property (e.g., rental houses, commercial buildings).
• Any gain above recaptured depreciation may qualify as Section 1231 LTCG (assuming holding period > 1 year).

Section 1245 Recapture (Personal Property)

Key Rules

• Entire amount of accumulated depreciation taken is subject to ordinary income recapture, up to the recognized gain.
• After depreciation amount is fully recaptured, any excess gain → Section 1231 LTCG.

Worked Illustration

• Purchase price of equipment: 450{,}000
• Accumulated depreciation: 375{,}040
• Adjusted basis: 450{,}000 - 375{,}040 = 74{,}960

Case A – Sale price 120{,}000

• Realized gain: 120{,}000 - 74{,}960 = 53{,}040
• Because gain 53{,}040 < accumulated depreciation 375{,}040 → 100% ordinary income under §1245.

Case B – Sale price 500{,}000

• Realized gain: 500{,}000 - 74{,}960 = 425{,}040
• Recapture portion: first 375{,}040 (equals accumulated depreciation) → ordinary income.
• Remaining gain: 425{,}040 - 375{,}040 = 50{,}000 → §1231 LTCG.

Case C – Sale price 485{,}000 (example stressed in lecture)

• Realized gain: 485{,}000 - 74{,}960 = 410{,}040
• Recapture: 375{,}040 → ordinary.
• Excess: 35{,}000 → LTCG if > 1-year holding period.

Practical Takeaways

• Heavy first-year write-offs (e.g., §179 expensing, 100% bonus depreciation) increase future recapture exposure.
• Tax preparers must verify depreciation schedules to compute correct ordinary-income portion.

Section 1250 Recapture (Real Property)

Key Rules

• Targets depreciation on real estate (rental houses, apartment buildings, warehouses).
• Unlike §1245, only the “additional depreciation” (depreciation exceeding straight-line) is subject to pure ordinary recapture.
  • However, for residential/commercial property placed in service after 1986, only straight-line is allowed; therefore classic §1250 ordinary recapture is rare.
• Modern rule: the portion of gain up to accumulated straight-line depreciation is taxed at max 25% (often referred to as the “unrecaptured §1250 gain” rate).
  • If taxpayer’s marginal rate < 25%, use lower marginal rate.
  • If marginal rate > 25%, cap at 25%.
• Remaining gain → §1231 LTCG (0 %, 15 %, or 20 % depending on income level).

Worked Illustration (Lecture Example)

• Purchase price (basis): 300{,}000
• Accumulated depreciation: 50{,}000
• Adjusted basis: 300{,}000 - 50{,}000 = 250{,}000

Sale price: 1{,}000{,}000

• Total gain: 1{,}000{,}000 - 250{,}000 = 750{,}000
• Unrecaptured §1250 portion: first 50{,}000 → taxed at lower of taxpayer’s ordinary rate or 25 %.
• Remaining gain: 750{,}000 - 50{,}000 = 700{,}000 → LTCG.

Calculation Sequence (forms)

1. Report transaction on Form 8949; flow to Schedule D.
2. Identify unrecaptured §1250 gain on Schedule D, Part III, line 19.
3. Use Qualified Dividends & Capital Gain Tax Worksheet (or 28%/25% Rate Gain Worksheet) to split tax between the 25% bucket and standard LTCG brackets.

Practical Observations

• Many landlords & investors overlook the 25% recapture tier, assuming all gain is LTCG.
• Even small depreciation (e.g., 2,000/yr on a condo) cumulates and later triggers the 25% rate.
• Advisable: educate clients at acquisition about eventual recapture consequences.

Comparative Snapshot – §1245 vs. §1250

Look-Back Provision (Mentioned, Not Covered)

• Applies to prior §1231 net losses within 5 preceding years.
• Forces recharacterization of current §1231 gain as ordinary to extent of prior unrecaptured §1231 losses.
• Skipped in lecture depth; awareness only.

Ethical & Practical Implications

• Mischaracterizing recapture as LTCG under-reports tax liability → preparer penalties under IRC §6694.
• Planning strategies:
  • Spreading sales across tax years to stay in lower brackets.
  • Like-kind exchange (§1031) to defer recognition (note: limited to real property after 2018 TCJA).
  • Cost segregation studies accelerate §1245 depreciation—boosting current deductions but enlarging future recapture.
• Communication: clarify to clients that “depreciation is not free”; it defers tax, possibly at a different rate.

Key Numerical & Formula Reminders

• Adjusted Basis:
  \text{Adjusted Basis} = \text{Original Cost} - \text{Accumulated Depreciation}
• Realized Gain/Loss:
  \text{Realized Gain} = \text{Amount Realized} - \text{Adjusted Basis}
• Recapture Portion (§1245):
  \text{Recapture} = \min{\text{Accum. Depreciation},\; \text{Realized Gain}}
• Unrecaptured §1250 Gain Rate: ≤ 25 %.

Filing Checklist for Dispositions Involving Depreciation

• ☐ Retrieve complete depreciation schedules (Form 4562 history).
• ☐ Verify holding period (> 1 year for §1231 classification).
• ☐ Compute adjusted basis & realized gain.
• ☐ Determine applicable recapture section (§1245 vs. §1250).
• ☐ Allocate gain between ordinary, 25% bucket, and LTCG.
• ☐ Complete Form 4797 Part III for recapture details.
• ☐ Transfer figures to Form 8949/Schedule D.
• ☐ Apply capital gain tax worksheets to calculate liability.
• ☐ Document assumptions for preparer due-diligence file.

Bottom-Line Summary

• Depreciation recapture converts some (or all) gain into higher-taxed ordinary income (or 25% rate).
• Correct categorization hinges on: asset type, accumulated depreciation, and holding period.
• For clients with significant property sales, early tax planning and accurate depreciation records are essential to avoid surprises at filing time.