What Is Depreciation Recapture Under Reg. 1.1245-1?

When a business invests in assets, it can claim depreciation deductions over time. These deductions reduce the asset’s value on the books, known as its basis, and lower the business’s taxable income. When that asset is later sold for more than its depreciated value, the depreciation recapture rules under Internal Revenue Code (IRC) Section 1245 may apply.

Section 1245 requires that a portion of the gain, equal to the depreciation previously claimed, be reclassified from a capital gain to ordinary income. This process recaptures the previous tax benefit and prevents taxpayers from converting ordinary income deductions into gains taxed at lower capital gains rates.

Defining Section 1245 Property

Section 1245 property refers to assets that have been subject to depreciation or amortization. The most common category is tangible personal property used in a trade or business, which includes machinery, equipment, vehicles, furniture, and fixtures. Any physical business asset that is not real estate is likely Section 1245 property.

The definition also extends to certain amortizable intangible assets. This includes patents, copyrights, and other intellectual property with a limited useful life. An intangible asset is considered Section 1245 property if it is subject to amortization under tax code provisions like Section 197.

Other tangible property that is not a building or its structural components but is used for specific business functions also qualifies. This includes property used as an integral part of manufacturing, production, or extraction, as well as facilities for research or bulk storage of fungible commodities. For example, a specialized humidifier installed in a plant for production purposes is Section 1245 property.

The rules also cover specific property types, including single-purpose agricultural or horticultural structures, storage facilities for petroleum distribution, and railroad grading. Buildings and their structural components, such as walls, roofs, and HVAC systems, are not Section 1245 property. These assets fall under a different set of rules known as Section 1250.

Calculating Depreciation Recapture

Calculating depreciation recapture requires three figures: the asset’s adjusted basis, the amount realized from its sale, and the total depreciation claimed. The adjusted basis is the original cost minus accumulated depreciation. The amount realized is the total value received for the asset, including cash, the fair market value of property received, and any liabilities the buyer assumes.

First, determine the total gain on the disposition by subtracting the asset’s adjusted basis from the amount realized. If the result is positive, there is a gain. If the result is a loss, the Section 1245 recapture rules do not apply.

Second, identify the total depreciation or amortization deductions taken on the property. The amount of gain treated as ordinary income is the lesser of either the total gain realized or the total depreciation claimed. Any gain that exceeds the recaptured amount is treated as a Section 1231 gain, which may qualify for capital gains treatment.

For example, a business buys machinery for $50,000 and claims $30,000 in depreciation, making the adjusted basis $20,000. The business sells the machinery for $40,000, resulting in a total gain of $20,000. The amount recaptured as ordinary income is the lesser of the $20,000 gain or the $30,000 in depreciation. Therefore, the entire $20,000 gain is recaptured as ordinary income.

Transactions Exempt from Recapture Rules

Certain transfers are exempt from the immediate application of Section 1245 rules. These exceptions do not eliminate the recapture potential but instead defer it or transfer it to another party.

One exception is the transfer of property as a gift. The donor does not recognize ordinary income at the time of the transfer. Instead, the recapture potential carries over to the recipient. If the recipient later sells the property at a gain, they become responsible for recapturing the depreciation deductions claimed by the original donor.

Transfers at death are another exception. When an individual dies and leaves Section 1245 property to an heir, the recapture rules do not apply. The heir receives the property with a “stepped-up” basis, which is the asset’s fair market value at the date of death, erasing the recapture potential.

Certain tax-free transactions also provide an exemption. In a like-kind exchange under Section 1031, recapture is deferred and carried over to the basis of the new property. In some corporate formations, such as transfers to a controlled corporation under Section 351 or contributions to a partnership under Section 721, recapture is not triggered unless non-qualifying property is received.

Reporting Recapture on Form 4797

Depreciation recapture is reported to the IRS on Form 4797, Sales of Business Property. This form is used to report gains and losses from the sale or exchange of property used in a trade or business. It ensures the gain is properly allocated between ordinary income and any potential capital gain.

Reporting a Section 1245 transaction begins in Part III of Form 4797. This section is designed to calculate the gain from dispositions of property subject to recapture. You will enter details about the property, including dates acquired and sold, the gross sales price, its cost basis, and the total depreciation allowed.

Part III guides the calculation to separate the ordinary income portion of the gain. The result is the total gain treated as ordinary income due to recapture. This amount is then carried from Part III to Part II of Form 4797 and combined with other ordinary gains and losses.

If the total gain on the sale exceeds the recaptured amount, this excess Section 1231 gain is reported on Part I of Form 4797. The net Section 1231 gain for the year may be treated as a long-term capital gain.