Editor: Anthony Bakale, CPA
Depreciation recapture provisions may be applied incorrectly in some situations and have implications that are overlooked in others. Their application can significantly affect the tax impact of a transaction in total or among various owners of an entity taxed as a partnership. After first providing background on Secs. 1245 and 1250, this item discusses how depreciation recapture applies in certain situations involving partnerships.
The general purpose of Secs. 1245 and 1250 is to require taxpayers that dispose of property used in a trade or business (specifically, Sec. 1231 property) to recharacterize all or a portion of their gain as ordinary income, due to prior depreciation deductions the taxpayer was allowed to take against ordinary income. Before discussing the recharacterization of gain, it is important to understand what types of property these depreciation recapture Code sections apply to.
In a general sense, Sec. 1250 applies to real property, and Sec. 1245 applies to personal property. However, under the definitions in both sections, some real property may fall under the Sec. 1245 rules. This distinction can be important, as will be discussed.
In its simplest form, Sec. 1245 requires a taxpayer to treat the gain on disposition of depreciable property as ordinary income. The amount subject to recharacterization is the lesser of (1) the prior depreciation deductions allowed or allowable; or (2) the taxpayer's gain on the property (Regs. Sec. 1.1245-1(a)).
Example 1: A and B are and have been since inception equal partners of Partnership AB. Partnership AB purchases Sec. 1245 property in year 1 for $200, and bonus depreciation is claimed for the entire amount. In a subsequent year, Partnership AB sells the property for $150. Partnership AB recognizes Sec. 1245 gain of $150, which is the lower of the recomputed basis ($200) or the amount realized ($150), minus the property's adjusted basis ($0).
Like Sec. 1245, Sec. 1250 may require a taxpayer to treat some of the gain on the disposition of depreciable property as ordinary income (Regs. Sec. 1.1250-1(a)(1)(i)). The amount subject to recharacterization is the lesser of (1) the additional depreciation attributable to periods after Dec. 31, 1975; or (2) the taxpayer's gain on the property (Sec. 1250(a)(1)(A)). Unlike Sec. 1245, Sec. 1250 does not look to the total depreciation deductions allowed or allowable but instead looks at the additional depreciation. What, then, is additional depreciation? Additional depreciation is defined in Regs. Secs. 1.1250-2(a)(1)(i) and (ii) as:
- In the case of property which at the time of disposition has a holding period under section 1223 of not more than 1 year, the "depreciation adjustments" (as defined in paragraph (d) of this section) in respect of such property for periods after December 31, 1963, and
- In the case of property which at the time of disposition has a holding period under section 1223 of more than 1 year, the depreciation adjustments in excess of straight line for periods after December 31, 1963, computed under paragraph (b)(1) of this section.
While Sec. 1250 only requires additional depreciation to be recaptured as ordinary income, Sec. 1(h)(1)(E) subjects unrecaptured Sec. 1250 gain to a maximum tax rate of 25%. Unrecaptured Sec. 1250 gain is the long-term capital gain that would be treated as ordinary income under Sec. 1250 if all depreciation was treated as additional depreciation (Sec. 1(h)(6)(A)(i)).
Example 2: In year 2, Partnership AB (described in Example 1) buys Sec. 1250 property for $200. In a subsequent year, when the property has an adjusted basis of $100, it is sold for $250, resulting in a gain of $150. At the time of the sale, additional depreciation is $20. Partnership AB recognizes Sec. 1250 gain of $20, the lesser of the additional depreciation ($20) or gain on the property ($150). The remaining gain of $130 would be broken down as: (1) $80 of unrecaptured Sec. 1250 gain ($100 of depreciation less $20 of Sec. 1250 gain); and (2) $50 of capital gain pursuant to Sec. 1231.
Now that the basics of Secs. 1245 and 1250 have been explained, this item will discuss some aspects of real property depreciation recapture in more detail and then look at situations involving the application of depreciation recapture rules in the partnership context.
Real property situations
Depreciable real property is often, but not always, depreciated utilizing the straight-line method. In these situations, Sec. 1250 would not be applicable since there would be no additional depreciation to recapture, but the unrecaptured Sec. 1250 gain rules may apply. However, there are a number of common circumstances where gains on the disposition of real property could be subject to recapture of prior depreciation, in whole or part, as ordinary income.
One common depreciation recapture example involves qualified improvement property (QIP). QIP includes certain improvements to the interior portion of nonresidential real property (Sec. 168(e)(6)). QIP is 15-year property subject to the straight-line method of depreciation but is eligible for bonus depreciation under Sec. 168(k). Since bonus depreciation allows for deductions in excess of those allowed under the straight-line method, such excess would be considered additional depreciation for purposes of Sec. 1250. The additional depreciation would be reduced going forward by the amount of straight-line depreciation the taxpayer would have been allowed for such year.
For example, consider a taxpayer that acquired $1,500 of QIP for which it claimed bonus depreciation in the year placed in service. The taxpayer would have been allowed $100 of straight-line depreciation per year if bonus depreciation had not been claimed. Therefore, the additional depreciation after each year would be calculated as the depreciation taken of $1,500 less the product of $100 times the number of years of straight-line deprecation. After year 3 the additional depreciation would be $1,200 ($1,500 − [$100 × 3]), assuming the full-year convention applied to the situation.
Another depreciation recapture example involves qualified Sec. 179 real property. Depreciable real property does not generally qualify for Sec. 179 deductions. However, the definition of Sec. 179 property has been expanded to include qualified real property (Sec. 179(d)(1)(B)(ii)). Qualified real property for this purpose includes QIP and certain improvements to nonresidential real property placed in service after the nonresidential real property was first placed in service, such as roofs, HVAC, fire protection and alarm systems, and security systems (id. at (e)). To the extent that Sec. 179 deductions are claimed on such property, the property becomes subject to the recapture rules under Sec. 1245 instead of Sec. 1250.
It is important for taxpayers to properly classify the property as Sec. 1245 upon disposition since any gain resulting from depreciation deductions, including the Sec. 179 deductions, will be recharacterized as ordinary income, as opposed to only the additional depreciation being recharacterized under Sec. 1250. Assume that in the earlier example, the taxpayer had taken $1,500 of Sec. 179 deductions instead of $1,500 of bonus depreciation. After year 3 the taxpayer would have up to $1,500 of ordinary income recapture under Sec. 1245 as opposed to having $1,200 of potential ordinary income recapture under Sec. 1250. In the case of the Sec. 179 expense deduction, time will not erase the ordinary income recapture taint.
Land improvements provide the last depreciation recapture example to look at. Land improvements, unless otherwise specified, have a 15-year modified accelerated cost recovery system (MACRS) recovery period and are eligible for bonus depreciation, as QIP is. However, their general depreciation method is not the straight-line method of depreciation. Instead, land improvements are subject to the 150% declining-balance method under Secs. 168(b)(3) and 168(b)(2)(A). The 150% declining-balance method is an accelerated depreciation method that would create additional depreciation in the early years of the asset's life. This additional depreciation amount would start being reduced in year 6 but not be fully eliminated until after the asset was fully depreciated after 15 years of depreciable service. For example, if the taxpayer placed a 15-year land improvement in service in year 1 using the 150% declining-balance method, the additional depreciation at different times would look as shown in the table "Comparison of Depreciation Methods, below."
In all these situations, how long the taxpayer will hold the property and/or the value of the property upon disposition will determine the ultimate impact of the ordinary income recapture under Secs. 1245 and 1250. Therefore, taxpayers need to understand how property will be depreciated and whether there are any alternative options or elections they can make that may lead to a better overall result in terms of depreciation recapture.
Turning now to another set of issues, the nature of a partnership can lead to situations where the recapture rules under Secs. 1245 and 1250 become more nuanced. Consider Example 1, discussed earlier. There the partnership had two equal partners since inception, and, assuming all allocations were pro rata, A and B would each be allocated half of the Sec. 1245 gain recognized by Partnership AB. However, what would happen if the property had been contributed by one of the partners, there was a change in the partnership ownership, or the partnership had made special allocations of depreciation?
Fortunately, the regulations under both Secs. 1245 and 1250 provide some guidance on these issues. While the present discussion cannot cover all the issues in this area, it is important for taxpayers and their professionals to address these issues to ensure any recharacterization is allocated correctly among the entity's partners. This discussion will focus on Regs. Sec. 1.1245-1 since the Sec. 1250 regulations provide that "the amount of gain recognized under section 1250(a) by the partnership and by a partner shall be determined in a manner consistent with the principles provided in paragraph (e) of §1.1245-1" (Regs. Sec. 1.1250-1(f)).
In general, a partner's distributive share of Sec. 1245 gain recognized by the partnership is equal to the lesser of (1) the partner's share of total gain from the disposition of the property or (2) the partner's share of depreciation or amortization with respect to the property (Regs. Sec. 1.1245-1(e)(2)(i)). In the case of contributed property, a partner's share of depreciation and amortization "includes the amount of depreciation or amortization allowed or allowable to the partner for the period before the property is contributed" (Regs. Sec. 1.1245-1(e)(2)(ii)(C)(1)). However, a partner's share of depreciation and amortization is adjusted to account for any curative or remedial allocations under Sec. 704(c) (Regs. Secs. 1.1245-1(e)(2)(ii)(C)(2) and (3)). While a discussion of the differences in Sec. 704(c) methods is beyond the scope of this discussion, it is important to know that the use of these methods will affect the allocation of Sec. 1245 gain among the partners differently in most cases. Any traditional, curative, or remedial allocations of ordinary income to the contributing partner will reduce (but not below zero) the contributing partner's — and increase the noncontributing partner's — share of depreciation and amortization with respect to that property by the amount of such special allocations.
Example 3: A and B form Partnership AB, and each is an equal partner. A contributed $1,000 cash, and B contributed Sec. 1245 property with an adjusted basis of $0 and fair market value (FMV) of $1,000. Prior to the contribution, B had acquired the property for $500 and claimed $500 of depreciation. Further assume the property uses the straight-line method and has a five-year recovery period. Partnership AB elects to use the remedial allocation method, which results in $200 of book depreciation ($1,000 ÷ 5) per year allocable equally to A andB.
Since A's allocable share of tax depreciation ($0) is less than A's share of book depreciation ($100), A will receive a $100 special allocation of depreciation, resulting in B having a greater allocation of net taxable income. After the first year, A's share of depreciation with respect to the property is $100 (tax depreciation plus remedial allocation of depreciation), and B's share of depreciation with respect to the property is $400 (depreciation claimed on the property prior to the contribution, less remedial allocation of deprecation to A). After the fifth year, A would have received $500 of remedial allocations of depreciation. Therefore, A's share of depreciation with respect to the property would be $500 and B's would be $0. As a result, if Partnership AB sold the property in year 6 for $1,000, it would recognize a gain of $1,000, of which $500 would be Sec. 1245 gain. The $1,000 gain would be allocated equally ($500) to A and B, but the Sec. 1245 gain of $500 would be allocated entirely toA.
Sec. 1245 gain can also arise when a partnership interest is sold. Sec. 741 provides that the gain on a sale or exchange of a partnership interest would be capital, except to the extent provided in Sec. 751. Sec. 751(a) applies to the sale or exchange of a partnership interest and treats amounts realized from certain partnership property, unrealized receivables, and inventory items as from other than a capital asset (i.e., ordinary gain). Included in the definition of unrealized receivables are Secs. 1245 and 1250 property. A selling partner's gain or loss subject to Sec. 751(a) is the amount that would have been allocated to the partner "if the partnership had sold all of its property in a fully taxable transaction for cash in an amount equal to the fair market value of such property" (Regs. Sec. 1.751-1(a)(2)).
Example 4: Assume that Partnership AB, owned equally by A and B, held one asset that was Sec. 1245 property that it purchased for $500 and had an adjusted basis of $0 but an FMV of $1,000. Further assume B, who has a $0 basis in its partnership interest, sells the interest to C for $500 (FMV of B's interest). B would recognize a gain of $500 (amount realized over adjusted basis) under Sec. 1001(a). If Partnership AB had sold the property for its FMV, B would have been allocated half of the gain ($500), of which $250 (the lesser of B's share of depreciation on the property or amount realized in excess of adjusted basis) would have been subject to Sec. 1245. Therefore, $250 of B's gain would be ordinary income.
In the above example, Partnership AB will need to wade through Regs. Sec. 1.1245-1(e) to determine the allocation of any Sec. 1245 gain upon an ultimate disposition of the property. The effect on C's purchase of the partnership interest in the above example may be best summarized in the preamble to regulations proposed in 2014 but not finalized, REG-151416-06:
The intent of the regulations under §1.1245-1(e)(3) is, in part, to ensure that a transferee partner does not recognize ordinary income with respect to section 1245 property to the extent a section 743 adjustment has displaced that ordinary income. For example, if a partner sells in a fully taxable exchange its interest in a partnership that has elected under section 754, and the selling partner recognizes ordinary income under section 751(a) with respect to partnership section 1245 property, then the rules under sections 1245 and 743 are intended to ensure that the transferee partner recognizes no ordinary income on an immediately subsequent disposition of the section 1245 property in a fully taxable transaction. However, the regulations under §1.1245-1(e)(3) have not been amended to take into account changes to subchapter K, including the regulations under section 751, resulting in issues and uncertainties. The IRS and the Treasury Department are studying these issues and request comments in this area.
To the extent that C is entitled to depreciation from the property, whether related to its allocation of tax depreciation on the property or its special basis adjustment under Sec. 743, Secs. 1245 and 1250 would apply. Sec. 751(a) has a corollary provision applicable to sales of partnership interests similar to the one under subsection (b) that applies to certain distributions. While the intent of subsection (b) is generally the same as that of subsection (a), taxpayers should make sure that they are applying the correct principles of Sec. 751, depending on the type of transaction.
In addition to the Sec. 751 aspects, application of the depreciation recapture rules to partnerships can be, as is often the case with partnerships, more onerous than for other taxpayers. Special allocations by the partnership of depreciation or gain are also addressed in Regs. Sec. 1.1245-1(e)(2). In today's partnership environment of targeted allocations and profits/carried interests, these rules are significant. Specifically, Examples 1 and 2 of Regs. Sec. 1.1245-1(e)(2)(iii) walk through situations of nonratable allocations and their impact on allocations of recapture.
The situations discussed above are by no means all the potential circumstances that require additional analysis to determine the proper amount and allocation of Secs. 1245 and 1250 recapture, but they do reflect some of the nuances that can be encountered and need to be addressed. Consideration of these matters should be given on the front end when deciding how property will be depreciated or how a transaction should be structured, and upon a sale or disposition of property, it is important to ensure that any allocations are made correctly. Taxpayers and their advisers need to understand the depreciation recapture rules to fully evaluate the tax consequences of various transactions.
Anthony Bakale, CPA, is a tax partner with Cohen & Company Ltd. in Cleveland.
For additional information about these items, contact Mr. Bakale at firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Cohen & Company Ltd.