| Publication 544 |
2008 Tax Year |
3.
Ordinary or Capital Gain or Loss for Business Property
When you dispose of business property, your taxable gain or loss is usually a section 1231 gain or loss. Its treatment as
ordinary or capital is
determined under rules for section 1231 transactions.
When you dispose of depreciable property (section 1245 property or section 1250 property) at a gain, you may have to recognize
all or part of the
gain as ordinary income under the depreciation recapture rules. Any remaining gain is a section 1231 gain.
Topics - This chapter discusses:
Useful Items - You may want to see:
Publication
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534
Depreciating Property Placed in Service Before 1987
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537
Installment Sales
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551
Basis of Assets
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946
How To Depreciate Property
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954
Tax Incentives for Distressed Communities
See chapter 5 for information about getting publications and forms.
Section 1231 Gains and Losses
Section 1231 gains and losses are the taxable gains and losses from section 1231 transactions. Their treatment as ordinary
or capital depends on
whether you have a net gain or a net loss from all your section 1231 transactions.
If you have a gain from a section 1231 transaction, first determine whether any of the gain is ordinary income under the depreciation
recapture
rules (explained later). Do not take that gain into account as section 1231 gain.
Section 1231 transactions.
The following transactions result in gain or loss subject to section 1231 treatment.
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Sales or exchanges of real property or depreciable personal property. This property must be used in a trade or business and held
longer than 1 year. Generally, property held for the production of rents or royalties is considered to be used in a trade
or business. Depreciable
personal property includes amortizable section 197 intangibles (described in chapter 2 under Other Dispositions).
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Sales or exchanges of leaseholds. The leasehold must be used in a trade or business and held longer than 1 year.
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Sales or exchanges of cattle and horses. The cattle and horses must be held for draft, breeding, dairy, or sporting purposes and
held for 2 years or longer.
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Sales or exchanges of other livestock. This livestock does not include poultry. It must be held for draft, breeding, dairy, or
sporting purposes and held for 1 year or longer.
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Sales or exchanges of unharvested crops. The crop and land must be sold, exchanged, or involuntarily
converted at the same time and to the same person and the land must be held longer than 1 year. You cannot keep any right
or option to directly or
indirectly reacquire the land (other than a right customarily incident to a mortgage or other security transaction). Growing
crops sold with a lease
on the land, though sold to the same person in the same transaction, are not included.
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Cutting of timber or disposal of timber, coal, or iron ore.
The cutting or disposal must be treated as a sale, as described in chapter 2 under Timber and Coal and
Iron Ore.
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Condemnations.
The condemned property must have been held longer than 1 year. It must be business property or a capital asset held
in connection with a trade or business or a transaction entered into for profit, such as investment property. It cannot be
property held for personal
use.
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Casualties and thefts.
The casualty or theft must have affected business property, property held for the production of rents and royalties, or
investment property (such as notes and bonds). You must have held the property longer than 1 year. However, if your casualty
or theft losses are more
than your casualty or theft gains, neither the gains nor the losses are taken into account in the section 1231 computation.
For more information on
casualties and thefts, see Publication 547.
Property for sale to customers.
A sale, exchange, or involuntary conversion of property held mainly for sale to customers is not a section 1231 transaction.
If you will get back
all, or nearly all, of your investment in the property by selling it rather than by using it up in your business, it is property
held mainly for sale
to customers.
Example.
You manufacture and sell steel cable, which you deliver on returnable reels that are depreciable property. Customers make
deposits on the reels,
which you refund if the reels are returned within a year. If they are not returned, you keep each deposit as the agreed-upon
sales price. Most reels
are returned within the 1-year period. You keep adequate records showing depreciation and other charges to the capitalized
cost of the reels. Under
these conditions, the reels are not property held for sale to customers in the ordinary course of your business. Any gain
or loss resulting from their
not being returned may be capital or ordinary, depending on your section 1231 transactions.
Copyrights.
The sale of a copyright, a literary, musical, or artistic composition, or similar property is not a section 1231
transaction if your personal
efforts created the property, or if you acquired the property in a way that entitled you to the basis of the previous owner
whose personal efforts
created it (for example, if you receive the property as a gift). The sale of such property results in ordinary income and
generally is reported in
Part II of Form 4797.
Treatment as ordinary or capital.
To determine the treatment of section 1231 gains and losses, combine all your section 1231 gains and losses for the
year.
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If you have a net section 1231 loss, it is ordinary loss.
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If you have a net section 1231 gain, it is ordinary income up to the amount of your nonrecaptured section 1231 losses from
previous years.
The rest, if any, is long-term capital gain.
Nonrecaptured section 1231 losses.
Your nonrecaptured section 1231 losses are your net section 1231 losses for the previous 5 years that have not been
applied against a net section
1231 gain by treating the gain as ordinary income. These losses are applied against your net section 1231 gain beginning with
the earliest loss in the
5-year period.
Example.
Ashley, Inc., a graphic arts company, is a calendar year corporation. In 2004, it had a net section 1231 loss of $8,000. For
tax years 2006 and
2007, the company has net section 1231 gains of $5,250 and $4,600, respectively. In figuring taxable income for 2006, Ashley
treated its net section
1231 gain of $5,250 as ordinary income by recapturing $5,250 of its $8,000 net section 1231 loss from 2004. In 2007, it applies
its remaining net
section 1231 loss, $2,750 ($8,000 - $5,250) against its net section 1231 gain, $4,600. For 2007, the company reports $2,750
as ordinary income
and $1,850 ($4,600 - $2,750) as long-term capital gain.
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 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 also must indicate the following information.
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Whether the adjusted basis was figured using depreciation or amortization you claimed on other property.
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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. Also see Publication 946.
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 defined.
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.
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Personal property (either tangible or intangible).
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Other tangible property (except buildings and their structural components) used as any of the following. See Buildings and structural
components below.
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An integral part of manufacturing, production, or extraction, or of furnishing transportation, communications, electricity,
gas, water, or
sewage disposal services.
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A research facility in any of the activities in (a).
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A facility in any of the activities in (a) for the bulk storage of fungible commodities (discussed on the next page).
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That part of real property (not included in (2)) with an adjusted basis reduced by (but not limited to) the following.
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Amortization of certified pollution control facilities.
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The section 179 expense deduction.
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Deduction for clean-fuel vehicles and certain refueling property placed in service before 2006.
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Deduction for capital costs incurred in complying with Environmental Protection Agency sulfur regulations.
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Deduction for certain qualified refinery property placed in service after August 8, 2005.
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Deduction for energy efficient commercial building property placed in service after December 31, 2005.
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Deduction for election to expense qualified advanced mine safety equipment property.
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Amortization of railroad grading and tunnel bores. (Repealed by Public Law 99-514, Tax Reform Act of 1986, section 242(a).)
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Certain expenditures for child care facilities. (Repealed by Public Law 101-58, Omnibus Budget Reconciliation Act of 1990,
section
11801(a)(13) except with regards to deductions made prior to November 5, 1990.)
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Expenditures to remove architectural and transportation barriers to the handicapped and elderly.
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Deduction for qualified tertiary injectant expenses.
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Certain reforestation expenditures.
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Single purpose agricultural (livestock) or horticultural structures.
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Storage facilities (except buildings and their structural components) used in distributing petroleum or any primary product
of petroleum.
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Any railroad grading or tunnel bore.
Buildings and structural components.
Section 1245 property does not include buildings and structural components. The term building includes a house, barn,
warehouse, or garage. The
term structural component includes walls, floors, windows, doors, central air conditioning systems, light fixtures, etc.
Do not treat a structure that is essentially machinery or equipment as a building or structural component. Also, do
not treat a structure that
houses property used as an integral part of an activity as a building or structural component if the structure's use is so
closely related to the
property's use that the structure can be expected to be replaced when the property it initially houses is replaced.
The fact that the structure is specially designed to withstand the stress and other demands of the property and cannot
be used economically for
other purposes indicates it is closely related to the use of the property it houses. 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, but as
section 1245 property.
Facility for bulk storage of fungible commodities.
This term includes oil or gas storage tanks and grain storage bins. 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. Materials are not fungible if 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.
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The depreciation and amortization allowed or allowable on the property.
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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) earlier 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 the amounts you claimed on the section 1245 property as well as the following
depreciation and amortization
amounts.
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Amounts you claimed on property you exchanged for, or converted to, your section 1245 property in a like-kind exchange or
involuntary
conversion. See Caution, below.
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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).
Simpler rules apply for section 1245 property you acquired after February 27, 2004. If you use MACRS, you can elect to continue
depreciating the
property exchanged or involuntarily converted as if the transfer had not occurred. The excess basis, if any, is treated as
newly placed in service
property. For details, see Figuring the Deduction for Property Acquired in a Nontaxable Exchange in chapter 4 of Publication
946.
Depreciation and amortization.
Depreciation and amortization that must be recaptured as ordinary income include (but are not limited to) the following
items.
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Ordinary depreciation deductions.
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Any special depreciation allowance you claimed.
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Amortization deductions for all the following costs.
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Acquiring a lease.
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Lessee improvements.
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Certified pollution control facilities.
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Certain reforestation expenses.
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Section 197 intangibles.
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Childcare facility expenses made before 1982.
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Franchises, trademarks, and trade names acquired before August 11, 1993.
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The section 179 deduction.
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Deductions for all the following costs.
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Removing barriers to the disabled and the elderly.
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Tertiary injectant expenses.
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Depreciable clean-fuel vehicles and refueling property (minus the amount of any recaptured deduction).
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Environmental cleanup costs.
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Certain reforestation expenses
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Any basis reduction for the investment credit (minus any basis increase for credit recapture).
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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 2005, 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 2005 and $3,200 in 2006.
You did not take the section 179 deduction. You sold the truck in May 2007 for $7,000. The MACRS deduction in 2007, the year
of sale, is $960 (1/ of $1,920). Figure the gain treated as ordinary income as follows.
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 can 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 can 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.
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.
Section 1250 property defined.
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 can never again treat
it as section 1250 property.
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 Gain Treated as Ordinary Income, earlier.
If you hold section 1250 property for 1 year or less, all the depreciation is additional depreciation.
You will not have additional depreciation if any of the following conditions apply to the property disposed of.
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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; you held the property longer than 1 year; and, if the property was
qualified New York
Liberty Zone property, you made a timely election not to claim any special depreciation allowance. In addition, if the property
was in a renewal
community, you must not have elected to claim a commercial revitalization deduction as figured under section 1400I of the
Internal Revenue Code.
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The property was residential low-income rental property you held for 16⅔ years or longer. For low-income rental housing on
which the special 60-month depreciation for rehabilitation expenses was allowed, the 16⅔ years start when the rehabilitated
property is
placed in service.
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You chose the alternate ACRS method for the property, which was a type of 15-, 18-, or 19-year real property covered by the
section 1250
rules.
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The property was 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); you held it longer than 1 year; and, if the property was qualified New York Liberty Zone property,
you made a timely
election not to claim any special depreciation allowance. These properties are depreciated using the straight line method.
In addition, if the
property was in a renewal community, you must not have elected to claim a commercial revitalization deduction as figured under
section 1400I of the
Internal Revenue Code.
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
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) generally is 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.
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.
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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.
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Low-income rental housing for which a depreciation deduction for rehabilitation expenses was allowed.
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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.
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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, 1995, you acquired low-income housing property. On April 3, 2006 (130 months after the property was acquired),
foreclosure proceedings
were started on the property and on December 3, 2007 (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, 2006,
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, 1991, the holding period starts on January 2, 1991. If you sold it on January
2, 2007, the holding
period is exactly 192 full months. The applicable percentage for additional depreciation is 8%, or 100% minus 1% for each
full month the property was
held over 100 full months.
Holding period for 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.
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A separate improvement (defined later).
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The basic section 1250 property plus improvements not qualifying as separate improvements.
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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, 2006, 50 on
July 18, 2006, and the
remaining 20 on January 18, 2007. As a result, the apartment house consists of three separate elements.
The 36-month test for separate improvements.
A separate improvement is any improvement (qualifying under The 1-year test, below) added to the capital account of the property, but
only 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.
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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.
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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).
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$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 of this year. During the year, the taxpayer
made improvements
A, B, and C, which cost $1,000, $600, and $700, respectively. The sum of the improvements, $2,300, is less than 1% of the
unadjusted basis ($3,000),
so the improvements 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 these improvements would have been $3,100. Then, it would 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.
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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 closest 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).
Step 1. 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 is $24,000.
Step 2. 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). $20,000 is lower than the $25,000 gain on the sale, so $20,000 is used
in Step 2.
Step 3. 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.....
|
.50
|
$10,000
|
68%
|
$ 6,800
|
|
X......
|
-0-
|
-0-
|
85%
|
-0-
|
|
Y......
|
.25
|
5,000
|
92%
|
4,600
|
|
Z......
|
.25
|
5,000
|
100%
|
5,000
|
Sum of ordinary income
of separate elements |
$16,400 |
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 earlier. 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 Form 4797, Part
III, line 26 (f).
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, include the recapture income in your
installment sale basis
to determine your gross profit on the installment sale.
If you dispose of more than one asset in a single transaction, you must figure the gain on each asset separately 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.
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. You report $10,000 of your $30,000 depreciation
as ordinary income on the
transfer of the property, so 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.
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 Sale 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 × 20%) and your section 1231 gain
is $200 ($1,200
- $1,000).
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 two
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 two 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 - $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. All
your replacement property is depreciable personal property, so 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. $114,000 of the $117,000 insurance payment was used to buy replacement property,
so the gain that must be
included in income under the rules for involuntary conversions is the part not spent, or $3,000. The part of the insurance
payment ($9,000) used to
buy the nondepreciable property (the stock) also must 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.
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 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 received 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.
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 in 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 in the following way. The amount 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 × $40,000, or $24,000. The amount allocated to the other
property is
20,000/50,000 × $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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