What Is Section 291 Recapture for C Corporations?

When a C corporation sells certain real estate at a gain, a tax rule known as Section 291 recapture may apply. This provision, found in Internal Revenue Code Section 291, recharacterizes a portion of the gain from the sale as ordinary income. The rule is designed to account for the depreciation deductions the corporation has taken over the years. While depreciation allows a business to recover the cost of an asset over its useful life, it also reduces the asset’s adjusted basis, leading to a larger taxable gain upon sale. Section 291 ensures that a fraction of this gain is taxed as ordinary income, reflecting the ordinary nature of the depreciation deductions that previously offset the company’s regular income.

Applicability of Section 291

Section 291 applies exclusively to C corporations. This means that other business structures, such as S corporations, partnerships, and sole proprietorships operated by individuals, are not subject to this specific recapture provision. When these other entities sell depreciable real property, they follow different recapture rules, primarily those under Section 1250, without the additional calculation mandated by Section 291.

This provision is triggered by the sale or disposition of an asset known as Section 1250 property. Section 1250 property is depreciable real property, which includes buildings like offices, warehouses, factories, and rental apartment buildings, along with their structural components. It does not cover the land on which these buildings sit, as land is not depreciable.

Section 1250 property should be distinguished from Section 1245 property. Section 1245 property includes tangible personal property used in a business, such as machinery, equipment, and vehicles. While both types of property are subject to depreciation recapture, Section 291 imposes an additional layer of ordinary income recapture only on the sale of Section 1250 real property by C corporations. The standard recapture rules for Section 1245 property are more stringent, often treating the entire gain attributable to depreciation as ordinary income.

The Recapture Calculation

Calculating the amount of ordinary income under Section 291 is based on a core calculation. The goal is to determine 20% of the “additional” amount that would have been treated as ordinary income if the property were Section 1245 property instead of Section 1250 property.

The first step is to determine the total recognized gain on the sale. This is calculated by subtracting the property’s adjusted basis from the sale price. The adjusted basis is the original cost of the property, plus any capital improvements, minus the total accumulated depreciation deductions taken over the years.

Next, the corporation must calculate a hypothetical recapture amount as if the property were Section 1245 property. For Section 1245 assets, the ordinary income recapture is the lesser of either the total gain on the sale or the total accumulated depreciation.

Following the hypothetical calculation, the actual ordinary income recapture under Section 1250 is determined. For most real property placed in service after 1986, the required depreciation method is straight-line. Under Section 1250, if straight-line depreciation was used, the ordinary income recapture is zero.

The actual Section 1250 recapture (often $0) is subtracted from the hypothetical Section 1245 recapture. The resulting difference is then multiplied by 20% to arrive at the Section 291 ordinary income amount.

For example, consider a C corporation that sells a building for $1 million. Its original cost was $800,000, and it has claimed $300,000 in straight-line depreciation, making the adjusted basis $500,000. The total gain is $500,000 ($1 million – $500,000). The hypothetical Section 1245 recapture would be $300,000 (the lesser of the $500,000 gain or the $300,000 accumulated depreciation). The actual Section 1250 recapture is $0, so the difference is $300,000, and 20% of that is $60,000.

Tax Treatment and Reporting

Once calculated, the Section 291 amount is treated as ordinary income. Any remaining gain is classified as a Section 1231 gain, which is treated as a long-term capital gain. For C corporations, a flat federal income tax rate applies to both ordinary income and capital gains, so the recharacterization does not change the tax rate on that portion of the gain.

The change in the character of the income is important. C corporations can only deduct capital losses to the extent of their capital gains. By converting a portion of the Section 1231 gain into ordinary income, Section 291 reduces the amount of capital gain available to absorb capital losses from other transactions during the tax year.

Using the previous example, the $60,000 of Section 291 recapture is ordinary income. The remaining $440,000 of the gain ($500,000 total gain – $60,000 ordinary income) is a Section 1231 gain. This bifurcation limits the corporation’s capital gain to $440,000, which in turn restricts its ability to deduct capital losses.

The entire transaction is reported on IRS Form 4797, Sales of Business Property. The gain from the sale is calculated in Part III of the form, which is used for property subject to depreciation recapture. The total ordinary income portion is carried to Part II and included on the corporation’s main tax return, Form 1120. The remaining Section 1231 gain is reported in Part I of Form 4797.