Understanding Depreciation Recapture Income Tax Liability
Arguably one of the most confusing income tax liabilities for investors in real estate to determine is the depreciation recapture income tax liability on the sale of investment property. While most investors are aware that they will be liable for depreciation taken that has not been offset by corresponding capital improvements in the property, actually determining the amount subject to recapture is often confusing; the rules relating to determination of depreciation recapture income tax liability have been substantially modified over time, and are quite specific and detail oriented. With this is in mind, the following article has been drafted only to give an explanation of depreciation recapture and the specific types of property subject to it, and a general concept of how the income tax liability is calculated, but investors would be well advised to work with qualified legal and tax advisors to determine their actual depreciation recapture income tax liability on their investment properties.
There are two code provisions relating to depreciation recapture: Section 1245 and Section 1250. In general, Section 1245 and 1250 are mutually exclusive, as section 1250 property is defined as any depreciable real property other than Section 1245 property. Section 1250(c). The two code provisions reflect the two general different types of property recognized for tax purposes in the United States: personal property is subject to recapture under Section 1245, but real property may be subject to either Section 1245 or Section 1250, depending on the use to which it is put and, for ACRS property, the recovery method chosen by the taxpayer. See Section 1245(a)(3), 1250(c), and 1245(a)(5)(as in effect before repeal by the 1986 TRA). The initial classification of property works differently for both code provisions as well. Property initially characterized as either Sec. 1245 property will remain characterized as such for the life of the property, meaning that once property has been classified as property depreciable under Section 1245, it will remain characterized as such so long as it remains in the hands of the same taxpayer even if the taxpayer never used the item as Section 1245 property. Regs. Section 1.1250-1(e)(4). This restriction does not apply to Section 1250 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. This means that in the case of Section 1250 property that has been converted to depreciation under Section 1245, when the property is sold and the taxpayer’s depreciation recapture tax liability is calculated, the entire depreciation recapture liability will be calculated under Section 1245, including the period of in which the property was characterized as Sec. 1250 property.
What is Section 1245 Property?
Section 1245 property includes all personal property, as well as certain types of real property subject to an allowance for depreciation, amortization, or special first-year expensing. See Section 1245(a)(3)(B)-(F). Section 1245 property need not have been subject to depreciation, amortization, or special expensing treatment either immediately before disposition or in the hands of the person selling the property, as it applies generally to property that “is or has been” depreciable in nature. Regs. Section 1.1245-3(a)(3).
It is important to note that there are circumstances where the taxpayer may be subject to depreciation recapture tax liability under Sec. 1245 even though property was not depreciable in the hands of the taxpayer himself. These are generally circumstances where the taxpayer’s basis in the property is determined by reference to the property’s basis in the hands of a prior owner, under which the property was either subject to an allowance for depreciation or actually depreciated under Section 1245. An example of such a situation would be where a Taxpayer 1 had an automobile used solely for use in the taxpayer’s business, which is later gifted to the Taxpayer’s son to use solely for personal enjoyment. In this situation, when the Taxpayer’s son sells the automobile, it is deemed to be Section 1245 property and subject to depreciation recapture because it was of a depreciable character in Taxpayer’s hands and the Taxpayer’s son’s basis in the automobile was determined by reference to Taxpayer’s basis because the automobile was received as a gift.
Example: Father makes a gift to son of an automobile previously used 100% in father's business. Thereafter, the son uses the car solely for personal purposes. The car is Section 1245 property in the hands of the son because it was of a depreciable character in the hands of the person from whom the car's basis carried over. Regs. Section 1.1245-3(a)(3).
Two Types of Personal Property: Tangible and Intangible
All personal property, whether tangible or intangible, is subject to depreciation recapture under Section 1245. It is important for investors and their advisors to be aware that local law definitions are not controlling for purposes of determining whether or not property is deemed to be “personal property” for federal tax purposes, so that items generally considered to be personal property under local law and certain items not treated as personal property under local law nevertheless will be considered Section 1245 personal property. Regs. Section 1.48-1(c). Further, the converse may also be true, meaning that 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. An example of where this disparity in local and federal characterization exists is presented in Rev. Rul. 67-433, where certain electrical heating, air conditioning, and water equipment was deemed to be tangible personal property for local tax purposes, but characterized by the IRS nonetheless as a "structural component" of a building constituting Section 1250 real property rather than Section 1245 personal property for federal tax purposes.
Tangible Personal Property
For recapture purposes, the term "tangible personal property" means all tangible property except land and improvements thereto, such as buildings or other inherently permanent structures. See Regs. Section 1.1245-3(b), 1.48-1(c). Property includable in this category typically breaks down into two subcategories: (1) property contained in and/or attached to a building and (2) assets in the nature of machinery.
Property Contained in or Attached to a Building
Personal property depreciable under Section 1245 typically includes all property contained in or attached to a building except structural components, even though such property might be considered a fixture and, therefore, real property under local law. Regs. Section 1.48-1(c). As one might imagine, this is an expansive category of property, including business assets such as production machinery, transportation and office equipment, display racks and shelves, neon and other signs contained in, or attached to, and any and all other fixtures that, while possibly characterized a real property by state law because they are permanently affixed to the property, are nonetheless not deemed to be “structural components” and therefore depreciable as Section 1245 property. Id.
Assets in the Nature of Machinery
Property in the nature of machinery that is not a structural component of a building or other inherently permanent structure, is depreciable under Section 1245 as personal property, even though typically located outside a building and considered to be a fixture and, therefore arguably real property under local law. Regs. Section 1.48-1(c). The IRS has a specific test to determine whether or not certain types of machinery and equipment are personal property rather than a structural component. Under this test, machinery and/or equipment are deemed depreciable personal property if: (1) its removal would not affect the continued operation of the building; and (2) the item is commonly used in the industry. Rev. Rul. 65-79, 1965-1 C.B. 26.
Section 197 Intangible Property
The Code defines a "section 197 intangibles" as most acquired intangibles, including “goodwill” and “going concern value” that have been acquired by the taxpayer after August 10, 1993 and held in connection with a trade or business or in an activity engaged in for the production of income. Section 197. Section 197 intangibles may be amortized over a fifteen (15) year period, starting from the month the taxpayer initially acquires the property and irrespective of the intangible asset's actual useful life. See Section 197, as added by 1993 RRA Section 13261. Accordingly, section 197 intangible property is treated as property of a character which is subject to the allowance for depreciation and constitutes property subject to depreciation recapture under Section 1245.
Other Intangible Property Subject to an Allowance for Depreciation
Intangible personal property subject to the allowance for depreciation also constitutes Section 1245 property, including personal property rights such as patents, copyrights, and subscription lists, employment contracts such as basketball and baseball player contracts, covenants not to compete which are subject to the allowance for depreciation, and media rights to films, video tapes and sound recordings. Regs. Section 1.167(a)-3. As these properties all provide for a depreciation allowance, these properties will, if disposed of at a gain, be subject to depreciation recapture under Section 1245.
There is another subset of intangible properties under which depreciation pursuant to Section 167 is never technically allowable, but they are nonetheless subject to Section 1245 solely because they are deemed to be of a "depreciable character." The type of property where this is of the greatest concern is typically leasehold interests in Section 1245 property. As mentioned above, Section 1245 applies only to property which is or has been property of a character subject to the allowance for depreciation under Section 167. Under the current regulations however, a leasehold interest in Section 1245 property is also Section 1245 property. Regs. Section 1.1245-3(a)(2); Regs. Section 1.1245-2(a)(3). The IRS supports this position by pointing to legal precedent holding that leasehold interests subject to amortization under the Section 162 regulations are of a depreciable "character", and although these decisions typically relate to a leasehold interests in land (Section 1250 property) and the specific issue was whether Section 1239 applied to the transfer, the IRS argues the determination is still relevant because both Section 1239 and Section 1245 apply "property of a character which is subject to the allowance for depreciation" under Section 167. Baker v. Commissioner, 38 T.C. 9 (1962). This holding does not extend however to leasehold interests in real property. Strangely enough, despite the fact that a leasehold interest in real property may be deemed to be personal property under local law and that certain authorities suggest that a leasehold interest of less than 30 years' duration in real property is personal property for income tax purposes, these interests are not subject to depreciation recapture pursuant to Section 1245, as the regulations specifically preclude these interests. See Regs. Section 1.1245-3; Regs. Section 1.1250-1(e)(3). Rather, the regulations state that property included in and subject to the lease must be analyzed to determine what portion of a leasehold interest is appropriately depreciable under Section 1245, and the determination of whether the leasehold interest falls under Section 1245 determined based on the nature of the underlying property. Regs. Section 1.1245-3. This means that in the situation where a tenant leases property consisting of land and a fully equipped factory building subject to MACRS, and sixty (60) percent of the value of the property is allocable to Section 1245 property (e.g. machinery and/or fixtures), then sixty (60) percent of the leasehold interest is subject to depreciation recapture as Section 1245 property, regardless of the term of the lease and its characterization at law as real or personal property.
To complicate matters, there are certain types of Section 1245 property where the calculation of depreciation recapture is complicated by the Accelerate Cost Recovery System (ACRS) concerns. ACRS generally replaced depreciation deductions allowed under Section 167 with recovery deductions for most depreciable property, defined as tangible property used in a trade or business or held for production of income and of a character subject to the allowance for depreciation, and placed in service after 1980 and before 1987. See Pre-1986 TRA Section 168(c)(1). Accordingly, “recovery property” was not defined to include intangible depreciable property, portions of the basis of tangible depreciable property the taxpayer properly elected to amortize or tangible depreciable property the taxpayer elected to depreciate under a method not expressed in terms of years. See Pre-1986 TRA Section 168(c), (d)(1), and (e)(2).
Recovery deductions taken under ACRS
generally are subject to recapture in a manner similar to depreciation deductions, so that the entire amount of recovery deductions are recaptured as depreciation under Section 1245 and any deductions in excess of straight-line are recaptured as ordinary income under Section 1250. See Section 1245(a)(2); Section 1250(b)(1), (3), (5). This is further complicated by a wrinkle in classification: properties subject to recovery deductions under ACRS are not always classified in a manner consistent with similar properties placed in service before or after ACRS, meaning there are situations in which certain real property otherwise subject to depreciation recapture pursuant to Section 1250 will be subject to Section 1245 recapture due to recovery deduction depreciation under ACRS. The pre-1986 Tax Reform Act Section 1245(a)(5) defines "Section 1245 recovery property" to include all recovery property under ACRS, real or personal, other than certain types of 19-year (18-year for property placed in service after March 15, 1984, and before May 9, 1985; and 15-year for property placed in service before March 16, 1984) real property and low-income housing, including: (1) residential rental property; (2) property used "predominantly" outside the United States; (3) property as to which an election to use straight-line recovery is in effect; and (4) certain low-income and federally insured residential property. See pre-1986 TRA Section 168(f)(2); Section 1250(a)(1)(B)(i)- (iv).
This means that these four types of 19-year (or 18- or 15-year) ACRS real property and low-income housing that have specifically defined as subject to recapture under Section 1250, and that all other ACRS real property is subject to recapture under Section 1245.
With certain exceptions, buildings are considered to be “improvements” characterized as Section 1250 property irrespective of their usage. For purposes of Section 1250, a "building" is defined as "any structure or edifice enclosing a space within its walls, and usually covered by a roof, the purpose of which is, for example, to provide shelter or housing, or to provide working, office, parking, display, or sales space” regardless of whether a building constructed by or for a lessee must be removed or whether ownership of the structure will revert to the lessor upon termination of the lease. Regs. Section 1.48-1(e)(1), incorporated by reference in Regs. Section 1.1245-3(c)(2), incorporated by reference in Regs. Section 1.1250-1(e)(3)(i). This means that while the structures commonly perceived to be “buildings” by investors qualify under Section 1250, some less clear examples such as aircraft hangers; baseball sports stadium; a natural gas and docking facilities used for loading and unloading trucks and trailers. All also qualify as “buildings” for the purposes of Section 1250. See Rev. Rul. 69-329, 1969-1 C.B. 30, Rev. Rul. 69-170, 1969-1 C.B. 28 and Rev. Rul. 71-203, 1971-1 C. B. 7.
Since the definition of “building” is relatively expansive, the IRS has established a "functional use" test to determine whether or not a structure should be classified as a building for purposes of Section 1250. Under this test, 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." Rev. Rul. 77-363, 1977-2 C.B. 10. Not all authorities endorse the “functional test”; another test used by some authorities in determining whether a structure should be classified as a building is the "appearance" test. The appearance test is in some respects a much simpler standard, as its focus is merely the outward appearance of a structure. Accordingly, under the appearance test, if the structure looks like a building, then its characterized as a building for purpose of Section 1250. Endres Floral Co. v. U.S. 450 F. Supp. 16(N.D. Ohio1977).
Inherently Permanent Structures or Structural Components
In addition to “buildings”, Section 1250 also applies to some tangible real property that falls outside the standard definition of a “building” or structural component of a building, but which is an "inherently permanent structure". The regulations provide that the following items are all structural components: walls, partitions, floors, and ceilings, as well as any permanent coverings such as paneling or tiling; windows and doors; all components (whether in, on, or adjacent to the building) of a central air conditioning or heating system including motors, compressors, pipes, and ducts; plumbing and plumbing fixtures, such as sinks and bathtubs; electric wiring and lighting fixtures; chimneys; stairs; sprinkler systems; fire escapes; and other components related to the operation or maintenance of a building. See Regs. Section 1.48-1(e)(2), Rev. Rul. 67-417, 1967-2 C.B. 49, and Rev. Rul. 67-433, 1967-2 C.B. 51. Just as with buildings, the IRS has specific tests for determining whether or not property is a “structural component” for purposes of Section 1250. The test used by the IRS to make the determination is the "accessorial" test, which looks to the conduct of the business in which the structure it is used, as determined by common use in the industry. If so structure is not something typically used to conduct business, then it is deemed merely accessorial which indicates that the property is not a "structural component" or an "inherently permanent structure" and thus is depreciable under Section 1245 instead of Section 1250. It is important for taxpayer’s to realize however that even permanence does not necessarily preclude the property from being “tangible personal property” subject to recapture under Section 1245. In Whiteco Industries, Inc. v. Commissioner, the Tax Court indicated that affixation to land does not necessarily demonstrate that a structure is inherently permanent and does not preclude property from being "tangible personal property" and listed the following factors in determining whether property is inherently permanent: (1) whether the property capable of being moved and has it been moved; (2) whether the property designed or constructed to remain permanently in place; (3) whether there are circumstances showing that the property may have to be moved; (4) whether the property "readily" removable; (5) whether and to what extent the property will sustain damage upon removal and; (6) the manner in which the property is affixed to the land.
Using the criteria established in Whiteco, the Tax Court has held that billboards now constitute tangible personal property under Section 1245, whereas before Whiteco the IRS had ruled that billboards and signs were inherently permanent structures.
Determining the Amount of Gain Subject to Recapture
In order to determine the amount of gain subject to recapture and treated as ordinary income on a disposition of property that triggers Section 1245 or Section 1250, taxpayers will find it necessary 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 (the “gain limitation”). Taxpayer’s and their advisors will also have to figure out the amounts previously claimed as depreciation for Section 1245 property, or as "additional depreciation" for Section 1250 property (the "depreciation limitation").
Generally, for property subject to recapture under Section 1245, the amount of gain treated as ordinary income under that section is either the gain limitation or the depreciation limitation, whichever is less. See Section 1245(a)(1). Technically, for Section 1250 property, it is also necessary to determine the "applicable percentage" in order to calculate the amount of gain subject to recapture as ordinary income and multiply the applicable percentage by the lower of the gain limitation or the depreciation limitation. Section 1250(a). Practically however the applicable percentage for most Section 1250 property will be 100%, so that the amount subject to recapture also be the lesser of the gain limitation or the depreciation limitation.
Dispositions Involving both Section 1245 and Section 1250 Property
When Section 1245 and non-Section 1245 property are disposed of in the same transaction, the amount realized is allocated to both types of property in proportion to their respective market values. If buyer and seller have adverse interests in determining the allocation, any arms length agreement between them will generally suffice to establish it. Without such an agreement, the allocation is made by taking into account "the appropriate facts and circumstances." Regs. Section 1.1245-1(a)(5).
Regardless of whether property is subject to recapture under Section 1245 or Section 1250, the amount subject to recapture cannot exceed the gain realized (i.e. the excess of the amount realized over the property's adjusted basis) or the "potential gain" (i.e. the excess of the property's fair market value over its adjusted basis). See Regs. Section 1.1245-1(c)(1). In a sale, exchange, or involuntary conversion of property, the gain realized by the taxpayer constitutes the gain limitation, while in all other dispositions, the “potential gain” constitutes the gain limitation. Section 1245(a)(1)(B), 1250(a)(1)(A)(ii), (2)(A)(ii), (3)(A)(ii). For the sake of clarity, what this means is in a theoretical arm's-length transaction, if property is disposed of by the taxpayer at a price equal to its adjusted basis, there is no Section 1245 or Section 1250 recapture upon its disposition regardless of the amount of depreciation previously claimed with respect to the property.
Taxpayer’s should be aware however that the gain limitation typically is not important with respect to Section 1250 property; although Section 1250 property is depreciated for income tax and accounting purposes, property of this nature at a minimum typically maintains value in excess of its depreciated book value and often outright appreciates in value, so that the gain limitation rarely will be lower than the depreciation limitation for an item of Section 1250 property. Where the gain limitation does come into play with respect to Section 1250 property, it may be necessary to break down the gain limitation into post-1975, 1970-1975, and pre-1970 components, depending on when the property was acquired and disposed of. See Section 1250(a)(1)(A)(ii), (2)(A)(ii), (3)(A)(ii).
Sales, Exchanges, and Involuntary Conversions
For sales, exchanges, and involuntary conversions, the gain limitation equals the gain realized on the disposition, or more simply put: the amount the taxpayer realizes in excess of the property's adjusted basis. Section 1245(a)(1)(B)(i), 1250(a)(1)(A)(ii), (2)(A)(ii), (3)(A)(ii).
In a sale, the gain limitation is the sales proceeds the taxpayer receives in excess of the property's adjusted basis. Id. Practically, what this means is that the depreciation recaptured as ordinary income cannot exceed the gain realized. So for example, if a taxpayer has an office building that was placed in service during 1980 and is sold in 1995 for $290,000 with an adjusted basis is $200,000 and the taxpayer had claimed $130,000 of "additional depreciation" (defined as depreciation in excess over straight-line depreciation) with respect to the property, the gain limitation on the transaction would be $90,000, the sales proceeds received over the 200,000 adjusted basis.
In tax deferred exchanges of property under Section 1031, the amount realized equals the fair market value of the property received in the exchange, and the gain limitation is the amount by which that value exceeds the adjusted basis of the property given up in the exchange. See Section 1245(a)(1)(B)(i), 1250(a)(1)(A)(ii); Regs. Section 1.1245- 1(b)(2). The tax deferred exchange process prevents the taxpayer from being responsible for paying any depreciation recapture due at the time, but whatever liability is deferred by the exchange process will follow the taxpayer and lower the adjusted basis of the replacement property or properties.
In the case of an involuntary conversion, the insurance proceeds or condemnation award constitute the amount realized, and the gain limitation is the excess of that amount over the adjusted basis of the involuntarily converted property. See Section 1245(a)(1)(B)(i), 1250(a)(1)(A)(ii), (2)(A)(ii), (3)(A)(ii).
As discussed above, the amount subject to recapture at any disposition of property under Section 1245 or Section 1250 is defined as the lesser of the gain limitation or the "depreciation limitation" (reduced by the applicable percentage in the case of certain Section 1250 property), and the amount of gain recaptured and treated as ordinary income under those sections cannot exceed either the gain or depreciation limitations. Generally, the "depreciation limitation" is the amount of depreciation or amortization taken with respect to Section 1245 property, ACRS Section 1245 recovery property, or Section 1250 property held less than one year; for Section 1250 property held more than one year, the depreciation limitation consists of the excess depreciation or amortization over straight-line. See Section 167(a), Section 168(a) as in effect before and after amendment by 1986 TRA Section 201(a).