If you dispose of depreciable or amortizable property at a gain,
you may have to treat all or part of the gain (even if otherwise
nontaxable) as ordinary income.
To figure any gain that must be reported as ordinary income, you
must keep permanent records of the facts necessary to figure the
amount of depreciation or amortization allowed or allowable on your
property. This includes the date and manner of acquisition, cost or
other basis, depreciation or amortization, and all other adjustments
that affect basis.
On property you acquired in a nontaxable exchange or as a gift,
your records must also indicate the following information.
- Whether the adjusted basis was figured using depreciation or
amortization you claimed on other property.
- Whether the adjusted basis was figured using depreciation or
amortization another person claimed.
Corporate distributions.
For information on property distributed by corporations, see
Distributions to Shareholders in Publication 542,
Corporations.
General asset accounts.
Different rules apply to dispositions of property you depreciated
using a general asset account. For information on these rules, see
section 1.168(i)-1(e) of the regulations.
Section 1245 Property
A gain on the disposition of section 1245 property is treated as
ordinary income to the extent of depreciation allowed or allowable on
the property. See Gain Treated as Ordinary Income, later.
Any gain recognized that is more than the part that is ordinary
income from depreciation is a section 1231 gain. See Treatment as
ordinary or capital under Section 1231 Gains and Losses,
earlier.
Section 1245 property.
Section 1245 property includes any property that is or has been
subject to an allowance for depreciation or amortization and that is
any of the following types of property.
- Personal property (either tangible or intangible).
- Other tangible property (except buildings and their
structural components) used as any of the following.
- An integral part of manufacturing, production, or extraction
or of furnishing transportation, communications, electricity, gas,
water, or sewage disposal services.
- A research facility in any of the activities in (a)
above.
- A facility in any of the activities in (a) for the bulk
storage of fungible commodities.
- That part of real property (not included in (2)) with an
adjusted basis that was reduced by certain amortization deductions
(including those for certified pollution control facilities,
child-care facilities, removal of architectural barriers to persons
with disabilities and the elderly, or reforestation expenses) or a
section 179 deduction.
- Single purpose agricultural (livestock) or horticultural
structures.
- Storage facilities (except buildings and their structural
components) used in distributing petroleum or any primary product of
petroleum.
Buildings and structural components.
Section 1245 property does not include buildings and structural
components. Do not treat structures that are essentially
items of machinery or equipment as buildings and structural
components. Also, do not treat as buildings structures that house
property used as an integral part of an activity if the structures'
use is so closely related to the property's use that the structures
can be expected to be replaced when the property they initially house
is replaced. The fact that the structures are specially designed to
withstand the stress and other demands of the property and the fact
that the structures cannot be used economically for other purposes
indicate that they are closely related to the use of the property they
house. Structures such as oil and gas storage tanks, grain storage
bins, silos, fractionating towers, blast furnaces, basic oxygen
furnaces, coke ovens, brick kilns, and coal tipples are not treated as
buildings.
Storage facility.
This is a facility used mainly for the bulk storage of fungible
commodities. Bulk storage means the storage of a commodity in a large
mass before it is used. For example, if a facility is used to store
oranges that have been sorted and boxed, it is not used for bulk
storage. To be fungible, a commodity must be such that one part may be
used in place of another. Stored materials that vary in composition,
size, and weight are not fungible. One part cannot be used in place of
another part and the materials cannot be estimated and replaced by
simple reference to weight, measure, and number. For example, the
storage of different grades and forms of aluminum scrap is not storage
of fungible commodities.
Gain Treated as Ordinary Income
The gain treated as ordinary income on the sale, exchange, or
involuntary conversion of section 1245 property, including a sale and
leaseback transaction, is the lesser of the following
amounts.
- The depreciation and amortization allowed or allowable on
the property.
- The gain realized on the disposition (the amount realized
from the disposition minus the adjusted basis of the property).
A limit on this amount for gain on like-kind exchanges and
involuntary conversions is explained later.
For any other disposition of section 1245 property, ordinary income
is the lesser of (1) above or the amount by which its fair market
value is more than its adjusted basis. See Gifts and
Transfers at Death, later.
Use Part III of Form 4797 to figure the ordinary income part of the
gain.
Depreciation taken on other property or taken by other
taxpayers.
Depreciation and amortization include not only the amounts you
claimed on the section 1245 property but also the following
depreciation and amortization amounts.
- Amounts you claimed on property you exchanged for, or
converted to, your section 1245 property in a like-kind exchange or
involuntary conversion.
- Amounts a previous owner of the section 1245 property
claimed if your basis is determined with reference to that person's
adjusted basis (for example, the donor's depreciation deductions on
property you received as a gift).
Depreciation and amortization.
Depreciation and amortization that must be recaptured as ordinary
income include (but are not limited to) the following items.
- Ordinary depreciation deductions.
- Amortization deductions for all the following costs.
- Acquiring a lease.
- Lessee improvements.
- Pollution control facilities.
- Reforestation expenses.
- Section 197 intangibles.
- Child care facility expenses made before 1982.
- Franchises, trademarks, and trade names acquired before
August 11, 1993.
- The section 179 expense deduction.
- Deductions for all the following costs.
- Removing barriers to the disabled and the elderly.
- Tertiary injectant expenses.
- Depreciable clean-fuel vehicles and refueling property
(minus the amount of any recaptured deduction).
- Any basis reduction for the investment credit (minus any
basis increase for credit recapture).
- Any basis reduction for the qualified electric vehicle
credit (minus any basis increase for credit recapture).
Example.
You file your returns on a calendar year basis. In February 1998,
you bought and placed in service for 100% use in your business a
light-duty truck (5-year property) that cost $10,000. You used the
half-year convention and your MACRS deductions for the truck were
$2,000 in 1998 and $3,200 in 1999. You did not take the section 179
deduction on it. You sold the truck in May 2000 for $7,000. The MACRS
deduction in 2000, the year of sale, is $960 (1/2 of $1,920). Figure
the gain treated as ordinary income as follows.
| 1) |
Amount realized |
$7,000 |
| 2) |
Cost (Feb. 1998) |
$10,000 |
| 3) |
Depreciation allowed or allowable (MACRS
deductions: $2,000 + $3,200 + $960) |
6,160 |
| 4) |
Adjusted basis (subtract line 3
from line 2) |
$3,840 |
| 5) |
Gain realized (subtract line 4
from line 1) |
$3,160 |
| 6) |
Gain treated as ordinary income
(lesser of line 3 or line 5) |
$3,160 |
Depreciation on other tangible property.
You must take into account depreciation during periods when the
property was not used as an integral part of an activity or did not
constitute a research or storage facility, as described earlier under
Section 1245 property.
For example, if depreciation deductions taken on certain storage
facilities amounted to $10,000, of which $6,000 is from the periods
before their use in a prescribed business activity, you must use the
entire $10,000 in determining ordinary income from depreciation.
Depreciation allowed or allowable.
The greater of the depreciation allowed or allowable is generally
the amount to use in figuring the part of gain to report as ordinary
income. If, in prior years, you have consistently taken proper
deductions under one method, the amount allowed for your prior years
will not be increased even though a greater amount would have been
allowed under another proper method. If you did not take any deduction
at all for depreciation, your adjustments to basis for depreciation
allowable are figured by using the straight line method.
This treatment applies only when figuring what part of gain is
treated as ordinary income under the rules for section 1245
depreciation recapture.
Multiple asset accounts.
In figuring ordinary income from depreciation, you may treat any
number of units of section 1245 property in a single depreciation
account as one item if the total ordinary income from depreciation
figured by using this method is not less than it would be if
depreciation on each unit were figured separately.
Example.
In one transaction you sold 50 machines, 25 trucks, and certain
other property that is not section 1245 property. All of the
depreciation was recorded in a single depreciation account. After
dividing the total received among the various assets sold, you figured
that each unit of section 1245 property was sold at a gain. You may
figure the ordinary income from depreciation as if the 50 machines and
25 trucks were one item.
However, if 5 of the trucks had been sold at a loss, only the 50
machines and 20 of the trucks could be treated as one item in
determining the ordinary income from depreciation.
Normal retirement.
The normal retirement of section 1245 property in multiple asset
accounts does not require recognition of gain as ordinary income from
depreciation if your method of accounting for asset retirements does
not require recognition of that gain.
Section 1250 Property
Gain on the disposition of section 1250 property is treated as
ordinary income to the extent of additional depreciation allowed or
allowable on the property. To determine the additional depreciation on
section 1250 property, see Additional Depreciation, later.
You will not have additional depreciation if any of the following
conditions apply to you.
- You figured depreciation for the property using the straight
line method or any other method that does not result in depreciation
that is more than the amount figured by the straight line method and
you have held the property longer than a year.
- You dispose of residential low-income rental property you
held for 16 2/3 years or longer (for low-income rental
housing on which the special 60-month depreciation for rehabilitation
expenses was allowed, the 16 2/3 years start when the
rehabilitated property is placed in service).
- You chose the alternate ACRS method for the types of 15-,
18-, or 19-year real property covered by the section 1250
rules.
- You dispose of residential rental property or nonresidential
real property placed in service after 1986 (or after July 31, 1986, if
the choice to use MACRS was made). These properties are depreciated
using the straight line method.
Section 1250 property.
This includes all real property that is subject to an allowance for
depreciation and that is not and never has been section 1245 property.
It includes a leasehold of land or section 1250 property subject to an
allowance for depreciation. A fee simple interest in land is not
included because it is not depreciable.
If your section 1250 property becomes section 1245 property because
you change its use, you may never again treat it as section 1250
property.
Gain Treated as Ordinary Income
To find what part of the gain from the disposition of section 1250
property is treated as ordinary income, follow these steps.
- In a sale, exchange, or involuntary conversion of the
property, figure the amount realized that is more than the adjusted
basis of the property. In any other disposition of the property,
figure the fair market value that is more than the adjusted
basis.
- Figure the additional depreciation for the periods after
1975.
- Multiply the lesser of (1) or (2) by the applicable
percentage, discussed later. Stop here if this is residential rental
property or if (2) is equal to or more than (1). This is the gain
treated as ordinary income because of additional depreciation.
- Subtract (2) from (1).
- Figure the additional depreciation for periods after 1969
but before 1976.
- Add the lesser of (4) or (5) to the result in (3). This is
the gain treated as ordinary income because of additional
depreciation.
A limit on the amount treated as ordinary income for gain on
like-kind exchanges and involuntary conversions is explained later.
Use Part III, Form 4797, to figure the ordinary income part of the
gain.
Corporations.
Corporations, other than S corporations, have an additional amount
to recognize as ordinary income on the sale or other disposition of
section 1250 property. The additional amount treated as ordinary
income is 20% of the excess of the amount that would have been
ordinary income if the property were section 1245 property over the
amount treated as ordinary income under section 1250. Report this
additional ordinary income on line 26(f) of Form 4797, Part III.
Additional Depreciation
If you hold section 1250 property longer than 1 year, the
additional depreciation is the actual depreciation adjustments that
are more than the depreciation figured using the straight line method.
For a list of items treated as depreciation adjustments, see
Depreciation and amortization under Section 1245
Property, earlier.
If you hold section 1250 property for 1 year or less, all the
depreciation is additional depreciation.
You will have additional depreciation if you use the regular ACRS
method, the declining balance method, the sum-of-the-years-digits
method, the units-of-production method, or any other method of rapid
depreciation. You also have additional depreciation if you choose
amortization, other than amortization on real property that qualifies
as section 1245 property, discussed earlier.
Depreciation taken by other taxpayers or on other property.
Additional depreciation includes all depreciation adjustments to
the basis of section 1250 property whether allowed to you or another
person (as for carryover basis property).
Example.
Larry Johnson gives his son section 1250 property on which he took
$2,000 in depreciation deductions, of which $500 is additional
depreciation. Immediately after the gift, the son's adjusted basis in
the property is the same as his father's and reflects the $500
additional depreciation. On January 1 of the next year, after taking
depreciation deductions of $1,000 on the property, of which $200 is
additional depreciation, the son sells the property. At the time of
sale, the additional depreciation is $700 ($500 allowed the father
plus $200 allowed the son).
Depreciation allowed or allowable.
The greater of depreciation allowed or allowable (to any person who
held the property if the depreciation was used in figuring its
adjusted basis in your hands) is generally the amount to use in
figuring the part of the gain to be reported as ordinary income. If
you can show that the deduction allowed for any tax year was less than
the amount allowable, the lesser figure will be the depreciation
adjustment for figuring additional depreciation.
Retired or demolished property.
The adjustments reflected in adjusted basis generally do not
include deductions for depreciation on retired or demolished parts of
section 1250 property unless these deductions are reflected in the
basis of replacement property that is section 1250 property.
Example.
A wing of your building is totally destroyed by fire. The
depreciation adjustments figured in the adjusted basis of the building
after the wing is destroyed do not include any deductions for
depreciation on the destroyed wing unless it is replaced and the
adjustments for depreciation on it are reflected in the basis of the
replacement property.
Figuring straight line depreciation.
The useful life and salvage value you would have used to figure
straight line depreciation are the same as those used under the
depreciation method you actually used. If you did not use a useful
life under the depreciation method actually used (such as with the
units-of-production method) or if you did not take salvage value into
account (such as with the declining balance method), the useful life
or salvage value for figuring what would have been the straight line
depreciation is the useful life and salvage value you would have used
under the straight line method.
Salvage value and useful life are not used for the ACRS method of
depreciation. Figure straight line depreciation for ACRS real property
by using its 15-, 18-, or 19-year recovery period as the property's
useful life.
The straight line method is applied without any basis reduction for
the investment credit.
Property held by lessee.
If a lessee makes a leasehold improvement, the lease period for
figuring what would have been the straight line depreciation
adjustments includes all renewal periods. This inclusion of the
renewal periods cannot extend the lease period taken into account to a
period that is longer than the remaining useful life of the
improvement. The same rule applies to the cost of acquiring a lease.
The term "renewal period" means any period for which the lease
may be renewed, extended, or continued under an option exercisable by
the lessee. However, the inclusion of renewal periods cannot extend
the lease by more than two-thirds of the period that was the basis on
which the actual depreciation adjustments were allowed.
Rehabilitation expenses.
A part of the special 60-month depreciation adjustment allowed for
rehabilitation expenses incurred before 1987 in connection with
low-income rental housing is additional depreciation. The additional
depreciation is the special depreciation adjustments that are more
than the adjustments that would have resulted if the straight line
method, normal useful life, and salvage value had been used.
Example.
On January 6, 2000, Fred Plums, a calendar year taxpayer, sold real
property in which the entire basis was from rehabilitation expenses of
$50,000 incurred in 1985. The property was placed in service on
January 3, 1986. Under the special depreciation provisions for
rehabilitation expenses, the property was depreciated under the
straight line method using a useful life of 60 months (5 years) and no
salvage value. If Fred had used the regular straight line method, he
would have used a salvage value of $5,000 and a useful life of 15
years, and would have had a depreciable basis of $45,000. Depreciation
under the straight line method would have been $3,000 each year (1/15
x $45,000). On January 1, 2000, the additional depreciation for
the property was $8,000, figured as follows.
| Depreciation
Claimed |
Straight Line
Depreciation |
Additional
Depreciation |
| 1986 |
$10,000 |
$ 3,000 |
$ 7,000 |
| 1987 |
10,000 |
3,000 |
7,000 |
| 1988 |
10,000 |
3,000 |
7,000 |
| 1989 |
10,000 |
3,000 |
7,000 |
| 1990 |
10,000 |
3,000 |
7,000 |
| 1991 |
| 3,000 |
(3,000) |
| 1992 |
| 3,000 |
(3,000) |
| 1993 |
| 3,000 |
(3,000) |
| 1994 |
| 3,000 |
(3,000) |
| 1995 |
| 3,000 |
(3,000) |
| 1996 |
| 3,000 |
(3,000) |
| 1997 |
| 3,000 |
(3,000) |
| 1998 |
|
3,000 |
(3,000) |
| 1999 |
|
3,000 |
(3,000) |
| Total |
$50,000 |
$42,000 |
$ 8,000 |
Applicable Percentage
The applicable percentage used to figure the ordinary income
because of additional depreciation depends on whether the real
property you disposed of is nonresidential real property, residential
rental property, or low-income housing. The percentages for these
types of real property are as follows.
Nonresidential real property.
For real property
that is not residential
rental property, the applicable percentage for periods after 1969 is
100%. For periods before 1970, the percentage is zero and no ordinary
income because of additional depreciation before 1970 will result from
its disposition.
Residential rental property.
For residential rental property (80% or more of the gross income is
from dwelling units) other than low-income housing, the applicable
percentage for periods after 1975 is 100%. The percentage for periods
before 1976 is zero. Therefore, no ordinary income because of
additional depreciation before 1976 will result from a disposition of
residential rental property.
Low-income housing.
Low-income housing includes
all the following types of residential rental property.
- Federally assisted housing projects if the mortgage is
insured under section 221(d)(3) or 236 of the National Housing Act or
housing financed or assisted by direct loan or tax abatement under
similar provisions of state or local laws.
- Low-income rental housing for which a depreciation deduction
for rehabilitation expenses was allowed.
- Low-income rental housing held for occupancy by families or
individuals eligible to receive subsidies under section 8 of the
United States Housing Act of 1937, as amended, or under provisions of
state or local laws that authorize similar subsidies for low-income
families.
- Housing financed or assisted by direct loan or insured under
Title V of the Housing Act of 1949.
The applicable percentage for low-income housing is 100% minus 1%
for each full month the property was held over 100 full months. If you
have held low-income housing at least 16 years and 8 months, the
percentage is zero and no ordinary income will result from its
disposition.
Foreclosure.
If low-income housing is disposed of because of foreclosure or
similar proceedings, the monthly applicable percentage reduction is
figured as if you disposed of the property on the starting date of the
proceedings.
Example.
On June 1, 1988, you acquired low-income housing property. On April
3, 1999 (130 months after the property was acquired), foreclosure
proceedings were started on the property and on December 2, 2000 (150
months after the property was acquired), the property was disposed of
as a result of the foreclosure proceedings. The property qualifies for
a reduced applicable percentage because it was held more than 100 full
months. The applicable percentage reduction is 30% (130 months minus
100 months) rather than 50% (150 months minus 100 months) because it
does not apply after April 3, 1999, the starting date of the
foreclosure proceedings. Therefore, 70% of the additional depreciation
is treated as ordinary income.
Holding period.
The holding period used to figure the applicable percentage for
low-income housing generally starts on the day after you acquired it.
For example, if you bought low-income housing on January 1, 1984, the
holding period starts on January 2, 1984. If you sold it on January 2,
2000, the holding period is exactly 192 full months. The applicable
percentage for additional depreciation is 8%, or 100% minus 1 percent
for each full month the property was held over 100 full months.
Constructed, reconstructed, or erected property.
The holding period used to figure the applicable percentage for
low-income housing you constructed, reconstructed, or erected starts
on the first day of the month it is placed in service in a trade or
business, in an activity for the production of income, or in a
personal activity.
Property acquired by gift or received in a tax-free transfer.
For low-income housing you acquired by gift or in a tax-free
transfer the basis of which is figured by reference to the basis in
the hands of the transferor, the holding period for the applicable
percentage includes the holding period of the transferor.
If the adjusted basis of the property in your hands just after
acquiring it is more than its adjusted basis to the transferor just
before transferring it, the holding period of the difference is
figured as if it were a separate improvement. See
Low-Income Housing With Two or More Elements, next.
Low-Income Housing
With Two or More Elements
If you dispose of low-income housing property that has two or more
separate elements, the applicable percentage used to figure ordinary
income because of additional depreciation may be different for each
element. The gain to be reported as ordinary income is the sum of the
ordinary income figured for each element.
The following are the types of separate elements.
- A separate improvement (defined later).
- The basic section 1250 property plus improvements not
qualifying as separate improvements.
- The units placed in service at different times before all
the section 1250 property is finished. For example, this happens when
a taxpayer builds an apartment building of 100 units and places 30
units in service (available for renting) on January 4, 1999, 50 on
July 18, 1999, and the remaining 20 on January 18, 2000. As a result,
the apartment house consists of three separate elements.
The 36-month test for separate improvements.
A separate improvement is an improvement (qualifying under The
1-year test, below) added to the capital account of the property
if the total of the improvements during the 36-month period ending on
the last day of any tax year is more than the greatest of the
following amounts.
- One-fourth of the adjusted basis of the property at the
start of the first day of the 36-month period, or the first day of the
holding period of the property, whichever is later.
- One-tenth of the unadjusted basis (adjusted basis plus
depreciation and amortization adjustments) of the property at the
start of the period determined in (1).
- $5,000.
The 1-year test.
An addition to the capital account for any tax year (including a
short tax year) is treated as an improvement only if the sum of all
additions for the year is more than the greater of $2,000 or 1% of the
unadjusted basis of the property. The unadjusted basis is figured as
of the start of that tax year or the holding period of the property,
whichever is later. In applying the 36-month test, improvements in any
one of the 3 years are omitted entirely if the total improvements in
that year do not qualify under the 1-year test.
Example.
The unadjusted basis of a calendar year taxpayer's property was
$300,000 on January 1, 1987. During that year, the taxpayer made
improvements A, B, and C, which cost $1,000, $600, and $700,
respectively. Since the sum of the improvements, $2,300, is less than
1% of the unadjusted basis ($3,000), the improvements in 1987 do not
satisfy the 1-year test and are not treated as improvements for the
36-month test. However, if improvement C had cost $1,500, the sum of
the 1987 improvements would have been $3,100. It would then be
necessary to apply the 36-month test to figure if the improvements
must be treated as separate improvements.
Addition to the capital account.
Any addition to the capital account made after the initial
acquisition or completion of the property by you or any person who
held the property during a period included in your holding period is
to be considered when figuring the total amount of separate
improvements.
The addition to the capital account of depreciable real property is
the gross addition not reduced by amounts attributable to
replaced property. For example, if a roof with an adjusted basis of
$20,000 is replaced by a new roof costing $50,000, the improvement is
the gross addition to the account, $50,000, and not the net addition
of $30,000. The $20,000 adjusted basis of the old roof is no longer
reflected in the basis of the property. The status of an addition to
the capital account is not affected by whether it is treated as a
separate property for determining depreciation deductions.
Whether an expense is treated as an addition to the capital account
may depend on the final disposition of the entire property. If the
expense item property and the basic property are sold in two separate
transactions, the entire section 1250 property is treated as
consisting of two distinct properties.
Unadjusted basis.
In figuring the unadjusted basis as of a certain date, include the
actual cost of all previous additions to the capital account plus
those that did not qualify as separate improvements. However, the cost
of components retired before that date is not included in the
unadjusted basis.
Holding period.
Use the following guidelines for figuring the applicable percentage
for property with two or more elements.
- The holding period of a separate element placed in service
before the entire section 1250 property is finished starts on the
first day of the month that the separate element is placed in
service.
- The holding period for each separate improvement qualifying
as a separate element starts on the day after the improvement is
acquired or, for improvements constructed, reconstructed, or erected,
the first day of the month that the improvement is placed in
service.
- The holding period for each improvement not
qualifying as a separate element takes the holding period of the
basic property.
If an improvement by itself does not meet the 1-year test (greater
of $2,000 or 1% of the unadjusted basis), but it does qualify as a
separate improvement that is a separate element (when grouped with
other improvements made during the tax year), determine the start of
its holding period as follows. Use the first day of a calendar month
that is the closest first day of a month to the middle of the tax
year. If there are two first days of a month that are equally close to
the middle of the year, use the earlier date.
Figuring ordinary income attributable to each separate
element.
Figure ordinary income attributable to each separate element as
follows.
Step 1. Divide the element's additional depreciation
after 1975 by the sum of all the elements' additional depreciation
after 1975 to determine the percentage used in Step 2.
Step 2. Multiply the percentage figured in Step 1 by the
lesser of the additional depreciation after 1975 for the entire
property or the gain from disposition of the entire property (the
difference between the fair market value or amount realized and the
adjusted basis).
Step 3. Multiply the result in Step 2 by the applicable
percentage for the element.
Example.
You sold at a gain of $25,000 low-income housing property subject
to the ordinary income rules of section 1250. The property consisted
of four elements (W, X, Y, and Z). The additional depreciation for
each element is: W--$12,000; X--None; Y--$6,000; and
Z--$6,000. The sum of the additional depreciation for all the
elements (Step 1) is $24,000. The depreciation deducted on element X
was $4,000 less than it would have been under the straight line
method. Additional depreciation on the property as a whole is $20,000
($24,000 - $4,000). Because $20,000 is lower than the $25,000
gain on the sale, $20,000 is used in Step 2. The applicable
percentages to be used in Step 3 for the elements are: W--68%;
X--85%; Y--92%; and Z--100%.
From these facts, the sum of the ordinary income for each element
is figured as follows.
| |
Step 1 |
Step 2 |
Step 3 |
Ordinary Income |
| W |
$12,000/$24,000 |
$10,000 |
68% |
$ 6,800 |
| X |
-0-/24,000 |
-0- |
85% |
-0- |
| Y |
6,000/24,000 |
5,000 |
92% |
4,600 |
| Z |
6,000/24,000 |
5,000 |
100% |
5,000 |
| Sum of ordinary income
of separate elements |
$16,400 |
Installment Sales
If you report the sale of property under the installment method,
any depreciation recapture under section 1245 or 1250 is taxable as
ordinary income in the year of sale. This applies even if no payments
are received in that year. If the gain is more than the depreciation
recapture income, report the rest of the gain using the rules of the
installment method. For this purpose, add the recapture income to the
property's adjusted basis.
If you dispose of more than one asset in a single
transaction, you must separately figure the gain on each asset so that
it may be properly reported. To do this, allocate the selling price
and the payments you receive in the year of sale to each asset. Report
any depreciation recapture income in the year of sale before using the
installment method for any remaining gain.
For a detailed discussion of installment sales, see Publication 537.
Gifts
If you make a gift of depreciable personal property or real
property, you do not have to report income on the transaction.
However, if the person who receives it (donee) sells or otherwise
disposes of the property in a disposition subject to recapture, the
donee must take into account the depreciation you deducted in figuring
the gain to be reported as ordinary income.
For low-income housing, the donee must take into account the
donor's holding period to figure the applicable percentage. See
Applicable Percentage and its discussion Holding
period under Section 1250 Property, earlier.
Part gift and part sale or exchange.
If you transfer depreciable personal property or real property for
less than its fair market value in a transaction considered to be
partly a gift and partly a sale or exchange and you have a gain
because the amount realized is more than your adjusted basis, you must
report ordinary income (up to the amount of gain) to recapture
depreciation. If the depreciation (additional depreciation, if section
1250 property) is more than the gain, the balance is carried over to
the transferee to be taken into account on any later disposition of
the property. However, see Bargain sale to charity, later.
Example.
You transferred depreciable personal property to your son for
$20,000. When transferred, the property had an adjusted basis to you
of $10,000 and a fair market value of $40,000. You took depreciation
of $30,000. You are considered to have made a gift of $20,000, the
difference between the $40,000 fair market value and the $20,000 sale
price to your son. You have a taxable gain on the transfer of $10,000
($20,000 sale price minus $10,000 adjusted basis) that must be
reported as ordinary income from depreciation. Because you report
$10,000 of your $30,000 depreciation as ordinary income on the
transfer of the property, the remaining $20,000 depreciation is
carried over to your son for him to take into account on any later
disposition of the property.
Gift to charitable organization.
If you give property to a charitable organization, you figure your
deduction for your charitable contribution by reducing the fair market
value of the property by the ordinary income and short-term capital
gain that would have resulted had you sold the property at its fair
market value at the time of the contribution. Thus, your deduction for
depreciable real or personal property given to a charitable
organization does not include the potential ordinary gain from
depreciation.
You also may have to reduce the fair market value of the
contributed property by the long-term capital gain (including any
section 1231 gain) that would have resulted had the property been
sold. For more information, see Giving Property That Has
Increased in Value in Publication 526,
Charitable
Contributions.
Bargain sale to charity.
If you transfer section 1245 or section 1250 property to a
charitable organization for less than its fair market value and a
deduction for the contribution part of the transfer is allowable, your
ordinary income from depreciation is figured under different rules.
First, figure the ordinary income as if you had sold the property at
its fair market value. Then, allocate that amount between the sale and
the contribution parts of the transfer in the same proportion that you
allocated your adjusted basis in the property to figure your gain.
(See Bargain Sales under Gain or Loss From Sales and
Exchanges in chapter 1.)
Report as ordinary income the lesser of
the ordinary income allocated to the sale or your gain from the sale.
Example.
You sold section 1245 property in a bargain sale to a charitable
organization and are allowed a deduction for your contribution. Your
gain on the sale was $1,200, figured by allocating 20% of your
adjusted basis in the property to the part sold. If you had sold the
property at its fair market value, your ordinary income would have
been $5,000. Your ordinary income is $1,000 ($5,000 x 20%) and
your section 1231 gain is $200 ($1,200 - $1,000).
Transfers at Death
When a taxpayer dies, no gain is reported on depreciable personal
property or real property transferred to his or her estate or
beneficiary. For information on the tax liability of a decedent, see
Publication 559,
Survivors, Executors, and Administrators.
However, if the decedent disposed of the property while alive and,
because of his or her method of accounting or for any other reason,
the gain from the disposition is reportable by the estate or
beneficiary, it must be reported in the same way the decedent would
have had to report it if he or she were still alive.
Ordinary income due to depreciation must be reported on a transfer
from an executor, administrator, or trustee to an heir, beneficiary,
or other individual if the transfer is a sale or exchange on which
gain is realized.
Example 1.
Janet Smith owned depreciable property that, upon her death, was
inherited by her son. No ordinary income from depreciation is
reportable on the transfer, even though the value used for estate tax
purposes is more than the adjusted basis of the property to Janet when
she died. However, if she sold the property before her death and
realized a gain and if, because of her method of accounting, the
proceeds from the sale are income in respect of a decedent reportable
by her son, he must report ordinary income from depreciation.
Example 2.
The trustee of a trust created by a will transfers depreciable
property to a beneficiary in satisfaction of a specific bequest of
$10,000. If the property had a value of $9,000 at the date used for
estate tax valuation purposes, the $1,000 increase in value to the
date of distribution is a gain realized by the trust. Ordinary income
from depreciation must be reported by the trust on the transfer.
Like-Kind Exchanges
and Involuntary
Conversions
A like-kind exchange of your depreciable property or an involuntary
conversion of the property into similar or related property will not
result in your having to report ordinary income from depreciation
unless money or property other than like-kind, similar, or related
property is also received in the transaction. For information on
like-kind exchanges and involuntary conversions, see chapter 1.
Depreciable personal property.
If you have a gain from either a like-kind exchange or an
involuntary conversion of your depreciable personal property, the
amount to be reported as ordinary income from depreciation is the
amount figured under the rules explained earlier (see Section
1245 Property), limited to the sum of the following
amounts.
- The gain that must be included in income under the rules for
like-kind exchanges or involuntary conversions.
- The fair market value of the like-kind, similar, or related
property other than depreciable personal property acquired in the
transaction.
Example 1.
You bought a new machine for $4,300 cash plus your old machine for
which you were allowed a $1,360 trade-in. The old machine cost you
$5,000 2 years ago. You took depreciation deductions of $3,950. Even
though you deducted depreciation of $3,950, the $310 gain ($1,360
trade-in allowance minus $1,050 adjusted basis) is not reported
because it is postponed under the rules for like-kind exchanges and
you received only depreciable personal property in the exchange.
Example 2.
You bought office machinery for $1,500 2 years ago and deducted
$780 depreciation. This year a fire destroyed the machinery and you
received $1,200 from your fire insurance, realizing a gain of $480
($1,200 minus $720 adjusted basis). You choose to postpone reporting
gain, but replacement machinery cost you only $1,000. Your taxable
gain under the rules for involuntary conversions is limited to the
remaining $200 insurance payment. Because all your replacement
property is depreciable personal property, your ordinary income from
depreciation is limited to $200.
Example 3.
A fire destroyed office machinery you bought for $116,000. The
depreciation deductions were $91,640, and the machinery had an
adjusted basis of $24,360. You received a $117,000 insurance payment,
realizing a gain of $92,640.
You immediately spent $105,000 of the insurance payment for
replacement machinery and $9,000 for stock that qualifies as
replacement property, and you choose to postpone reporting the gain.
Because $114,000 of the $117,000 insurance payment was used to buy
replacement property, the gain that must be included in income under
the rules for involuntary conversions is the unexpended part, or
$3,000. The part of the insurance payment ($9,000) used to buy the
nondepreciable property (the stock) must also be included in figuring
the gain from depreciation.
The amount you must report as ordinary income on the transaction is
$12,000, figured as follows.
| 1) |
Gain realized on the transaction ($92,640) limited to depreciation ($91,640) |
$91,640 |
| 2) |
Gain includible in income (unexpended amount)
|
$3,000 |
|
| Plus: FMV of property other than depreciable personal property (the stock) |
9,000 |
12,000 |
| Amount reportable as ordinary income (lesser of (1) or (2)) |
$12,000 |
If, instead of buying $9,000 in stock, you bought $9,000 worth of
depreciable personal property similar or related in use to the
destroyed property, you would only report $3,000 as ordinary income.
Depreciable real property.
If you have a gain from either a like-kind exchange or involuntary
conversion of your depreciable real property, ordinary income from
additional depreciation is figured under the rules explained earlier
(see Section 1250 Property), limited to the greater
of the following amounts.
- The gain that must be reported under the rules for like-kind
exchanges or involuntary conversions plus the fair market
value of stock bought as replacement property in acquiring control of
a corporation.
- The gain you would have had to report as ordinary income
from additional depreciation had the transaction been a cash sale
minus the cost (or fair market value in an exchange) of the
depreciable real property acquired.
The ordinary income not reported for the year of the disposition is
carried over to the depreciable real property acquired in the
like-kind exchange or involuntary conversion as additional
depreciation from the property disposed of. Further, to figure the
applicable percentage of additional depreciation on low-income housing
to be treated as ordinary income, the holding period starts over for
the new property.
Example.
The state paid you $116,000 when it condemned your depreciable real
property for public use. You bought other real property similar in use
to the property condemned for $110,000 ($15,000 for depreciable real
property and $95,000 for land). You also bought stock for $5,000 to
get control of a corporation owning property similar in use to the
property condemned. You choose to postpone reporting the gain. If the
transaction had been a sale for cash only, under the rules described
earlier, $20,000 would have been reportable as ordinary income because
of additional depreciation.
The ordinary income to be reported is $6,000, which is the greater
of the following amounts.
- The gain that must be reported under the rules for
involuntary conversions, $1,000 ($116,000 - $115,000) plus
the fair market value of stock bought as qualified replacement
property, $5,000, for a total of $6,000.
- The gain you would have had to report as ordinary income
from additional depreciation ($20,000) had this transaction been a
cash sale minus the cost of the depreciable real property
bought ($15,000), or $5,000.
The ordinary income not reported, $14,000 ($20,000 - $6,000),
is carried over to the depreciable real property you bought as
additional depreciation.
Basis of property acquired.
If the ordinary income you have to report because of additional
depreciation is limited, the total basis of the property you acquired
is its fair market value (its cost, if bought to replace property
involuntarily converted into money) minus the gain postponed.
If you acquired more than one item of property, allocate the total
basis among the properties in proportion to their fair market value
(their cost, in an involuntary conversion into money). However, if you
acquired both depreciable real property and other property, allocate
the total basis as follows.
- Subtract the ordinary income because of additional
depreciation that you do not have to report from the fair market value
(or cost) of the depreciable real property acquired.
- Add the fair market value (or cost) of the other property
acquired to the result in (1).
- Divide the result in (1) by the result in (2).
- Multiply the total basis by the result in (3). This is the
basis of the depreciable real property acquired. If you acquired more
than one item of depreciable real property, allocate this basis amount
among the properties in proportion to their fair market value (or
cost).
- Subtract the result in (4) from the total basis. This is the
basis of the other property acquired. If you acquired more than one
item of other property, allocate this basis amount among the
properties in proportion to their fair market value (or cost).
Example 1.
In 1986, low-income housing property that you acquired and placed
in service in 1981 was destroyed by fire, and you received a $90,000
insurance payment. The property's adjusted basis was $38,400, with
additional depreciation of $14,932. On December 1, 1986, you used the
insurance payment to acquire and place in service replacement
low-income housing property.
Your realized gain from the involuntary conversion was $51,600
($90,000 - $38,400). You chose to postpone reporting the gain
under the involuntary conversion rules. Under the rules for
depreciation recapture on real property, the ordinary gain was
$14,932, but you did not have to report any of it because of the limit
for involuntary conversions.
The basis of the replacement low-income housing property was its
$90,000 cost minus the $51,600 gain you postponed, or $38,400. The
$14,932 ordinary gain you did not report is treated as additional
depreciation on the replacement property. When you dispose of the
property, your holding period for figuring the applicable percentage
of additional depreciation to report as ordinary income will have
begun December 2, 1986, the day after you acquired the property.
Example 2.
John Adams gets a $90,000 fire insurance payment for depreciable
real property (office building) with an adjusted basis of $30,000. He
uses the whole payment to buy property similar in use, spending
$42,000 for depreciable real property and $48,000 for land. He chooses
to postpone reporting the $60,000 gain realized on the involuntary
conversion. Of this gain, $10,000 is ordinary income from additional
depreciation but is not reported because of the limit for involuntary
conversions of depreciable real property. The basis of the property
bought is $30,000 ($90,000 - $60,000), allocated as follows.
- The $42,000 cost of depreciable real property minus $10,000
ordinary income not reported is $32,000.
- The $48,000 cost of other property (land) plus the $32,000
figured in (1) is $80,000.
- The $32,000 figured in (1) divided by the $80,000 figured in
(2) is 0.4.
- The basis of the depreciable real property is $12,000. This
is the $30,000 total basis multiplied by the 0.4 figured in
(3).
- The basis of the other property (land) is $18,000. This is
the $30,000 total basis minus the $12,000 figured in (4).
The ordinary income that is not reported ($10,000) is carried over
as additional depreciation to the depreciable real property that was
bought and may be taxed as ordinary income on a later disposition.
Multiple Properties
If you dispose of both depreciable property and other property in
one transaction and realize a gain, you must allocate the amount
realized between the two types of property in proportion to their
respective fair market values to figure the part of your gain to be
reported as ordinary income from depreciation. Different rules may
apply to the allocation of the amount realized on the sale of a
business that includes a group of assets. See chapter 2.
In general, if a buyer and seller have adverse interests as to the
allocation of the amount realized between the depreciable property and
other property, any arm's-length agreement between them will establish
the allocation.
In the absence of an agreement, the allocation should be made by
taking into account the appropriate facts and circumstances. These
include, but are not limited to, a comparison between the depreciable
property and all the other property being disposed of in the
transaction. The comparison should take into account all the following
facts and circumstances.
- The original cost and reproduction cost of construction,
erection, or production.
- The remaining economic useful life.
- The state of obsolescence.
- The anticipated expenditures required to maintain, renovate,
or modernize the properties.
Like-kind exchanges and involuntary conversions.
If you dispose of and acquire both depreciable personal property
and other property (other than depreciable real property) in a
like-kind exchange or involuntary conversion, the amount realized is
allocated the following way. The amount allocated to the depreciable
personal property disposed of is treated as consisting of, first, the
fair market value of the depreciable personal property acquired and,
second (to the extent of any remaining balance), the fair market value
of the other property acquired. The amount allocated to the other
property disposed of is treated as consisting of the fair market value
of all property acquired that has not already been taken into account.
If you dispose of and acquire depreciable real property and other
property in a like-kind exchange or involuntary conversion, the amount
realized is allocated the following way. The amount that is allocated
to each of the three types of property (depreciable real property,
depreciable personal property, or other property) disposed of is
treated as consisting of, first, the fair market value of that type of
property acquired and, second (to the extent of any remaining
balance), any excess fair market value of the other types of property
acquired. (If the excess fair market value is more than the remaining
balance of the amount realized and is from both of the other two types
of property, you can apply the unallocated amount in any manner you
choose.)
Example.
A fire destroyed your property with a total fair market value of
$50,000. It consisted of machinery worth $30,000 and nondepreciable
property worth $20,000. You received an insurance payment of $40,000
and immediately used it with $10,000 of your own funds (for a total of
$50,000) to buy machinery with a fair market value of $15,000 and
nondepreciable property with a fair market value of $35,000. The
adjusted basis of the destroyed machinery was $5,000 and your
depreciation on it was $35,000. You choose to postpone reporting your
gain from the involuntary conversion. You must report $9,000 as
ordinary income from depreciation arising from this transaction,
figured as follows.
- The $40,000 insurance payment must be allocated between the
machinery and the other property destroyed in proportion to the fair
market value of each. The amount allocated to the machinery is
30,000/50,000 of $40,000, or $24,000. The amount allocated to the
other property is 20,000/50,000 of $40,000, or $16,000. Your gain on
the involuntary conversion of the machinery is $24,000 minus $5,000
adjusted basis, or $19,000.
- The $24,000 allocated to the machinery disposed of is
treated as consisting of the $15,000 fair market value of the
replacement machinery bought and $9,000 of the fair market value of
other property bought in the transaction. All $16,000 allocated to the
other property disposed of is treated as consisting of the fair market
value of the other property that was bought.
- Your potential ordinary income from depreciation is $19,000,
the gain on the machinery, because it is less than the $35,000
depreciation. However, the amount you must report as ordinary income
is limited to the $9,000 included in the amount realized for the
machinery that represents the fair market value of property other than
the depreciable property you bought.
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