FOR LIVE PROGRAM ONLY Calculating Depreciation Recapture Under IRC 1245 and 1250: Minimizing Tax Through Transaction Planning TUESDAY , AUGUST 15, 2017, 1:00-2:50 pm Eastern IMPORTANT INFORMATION FOR THE LIVE PROGRAM This program is approved for 2 CPE credit hours . To earn credit you must: • Participate in the program on your own computer connection (no sharing) – if you need to register additional people, please call customer service at 1-800-926-7926 x10 (or 404-881-1141 x10). Strafford accepts American Express, Visa, MasterCard, Discover . • Listen on-line via your computer speakers. • Respond to five prompts during the program plus a single verification code . You will have to write down only the final verification code on the attestation form, which will be emailed to registered attendees. • To earn full credit, you must remain connected for the entire program. WHO TO CONTACT DURING THE LIVE EVENT For Additional Registrations : -Call Strafford Customer Service 1-800-926-7926 x10 (or 404-881-1141 x10) For Assistance During the Live Program : -On the web, use the chat box at the bottom left of the screen If you get disconnected during the program, you can simply log in using your original instructions and PIN.
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Calculating Depreciation Recapture Under IRC 1245 and 1250 Aug. 15, 2017 Heather Behrend Norton Rose Fulbright US, New York heather.behrend@nortonrosefulbright.com Michael Plaks, E.A. REI Tax Firm, Houston service@michaelplaks.com
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DEPRECIATION RECAPTURE § 1245 and § 1250 Michael Plaks, EA Heather Behrend (713) 721-3321 (212) 408-5332 www.MichaelPlaks.com heather.behrend@nortonrosefulbright.com service@MichaelPlaks.com Houston, Texas
REI Tax Firm - Michael Plaks, EA www.MichaelPlaks.com What is Depreciation Recapture? example A: “break - even” resale 6
REI Tax Firm - Michael Plaks, EA www.MichaelPlaks.com What is Depreciation Recapture? example B: profitable resale 7
REI Tax Firm - Michael Plaks, EA www.MichaelPlaks.com What is Depreciation Recapture? example C: unprofitable resale 8
REI Tax Firm - Michael Plaks, EA www.MichaelPlaks.com What is Depreciation Recapture? example D: resale after Sec. 179 9
REI Tax Firm - Michael Plaks, EA www.MichaelPlaks.com What is Depreciation Recapture? • Depreciation is not a freebie – it is a loan • Taxable gain from profitable disposition consists of two parts: increase in value of the asset (appreciation & inflation) and reversal of prior depreciation deductions (recapture) • Because of depreciation recapture, taxable gain is possible even from unprofitable disposition! 10
REI Tax Firm - Michael Plaks, EA www.MichaelPlaks.com What is Depreciation Recapture? • Depreciation recapture triggers unexpected extra taxes, often to clients’ shock • Depreciation recapture is taxed very differently for two types of assets: Section 1250 assets – most real property Section 1245 assets – most other business assets • Whenever there is complexity – there are tax planning opportunities! (and CPA job security) 11
Background • Historically, treatment of depreciable property, created a mismatch because depreciation could be deducted from ordinary income, but gains were taxed as capital gains • Example: a taxpayer takes $30k of depreciation deductions on property, and later sells the property for a gain of $30k. Today, the depreciation deductions would be worth $11,880, based on the top marginal ordinary rate of 39.6%. Without recapture, the tax on the resulting gain would only be $6k, based on the capital gains rate of 20%. This results in a $5,880 tax benefit to the taxpayer 12
Background (cont’d) • § 1245 and § 1250 were enacted to fix this mismatch by taxing the part of the gain attributable to depreciation at ordinary rates. This corrective recharacterization is known as “recapture” • Subsequent legislation reduced the importance of recapture rules • For example, corporations no longer face different rates for capital gains and ordinary income, eliminating the need for recapture • However, the rules are still important for individuals, S Corps., partnerships, etc. 13
What is Depreciation Recapture? • The recapture rules are essentially asking a question: how much gain is attributable to depreciation deductions? • Example: a taxpayer buys depreciable property for $50k. Taxpayer’s basis starts at $50k, but depreciation deductions decrease this basis to $40k. Later, taxpayer sells the property for $60k, resulting in a gain of $20k. Only $10k of this gain is attributable to depreciation deductions so recapture only applies to that $10k of gain 14
§ 1245 Property • All personal property • Certain types of real property • Investment credit property – tangible real property, other than a building and its structural components, used as an “integral part” of or in connection with certain specified activities • Other specific real property • For example, § 179 property, pollution control facilities ( § 169), architectural and transportation barrier removals ( § 190), etc. 15
§ 1245 Property - “Integral Part” Test • The “Integral Part” test looks at whether property is • (1) used directly in one of the specified activities; and • (2) essential to the completeness of the activity • Specified activities include manufacturing, production, extraction, and providing transportation, communications, electrical energy, gas, water, and sewage disposal services • For example, fences used to confine livestock on a farm, a sewer system used by a natural gas transmission company, and fire-safety walls used at an oil refinery 16
§ 1250 Property • All real property that is not § 1245 property • For example, apartment buildings, factories, stores, sports stadiums, and aircraft hangers 17
Why Two Sections? • Two sections arose because Congress believed gain was attributable to different things in different types of property • For § 1245, which covers all personal property and some real property, and the assumption was that gain only resulted from depreciation deductions, not an increase in fair market value; without the deductions, personal property would simply decrease in value and be sold at a loss • Thus, § 1245 is an objective rule that does not allow taxpayers to prove that gain is from an increase in value 18
Why Two Sections? (cont’d) • § 1245 can be unfavorable to taxpayers: • Example: taxpayer buys a car for $30k, takes $10k of deductions, and sells the car for $32k twenty years later. The $12k of gain is the cap on recapture, so the full $10k of deductions can be recaptured. However, $32k in twenty years may only be worth $25k at the time the car was purchased. If the taxpayer had sold the car for $25k then recapture would be limited to $5k, but the taxpayer is not allowed to prove this 19
Why Two Sections? (cont’d) • For § 1250, which covers many types of real property, the assumption was that this property is held for a long time, so gain was attributable to inflation. Thus, recapture only applies to depreciation deductions taken in excess of the actual wear and tear, assuming the real property was held for more than one year • Note: the amount of deductions under the straight-line method is used as a substitute for the actual wear and tear 20
Why Two Sections? (cont’d) • § 1250 can be favorable to taxpayers: • Example: A taxpayer buys an apartment building in a city for $500k and takes straight-line depreciation deductions totaling $250k. The city becomes a popular place to live and taxpayer sells the apartment building for $750k. By applying the logic underlying § 1250, there would be no recapture on such property even though some gains are clearly attributable to a rise in demand (not just inflation). • Note: The Taxpayer Relief Act of 1997 resolves this by imposing a 25% tax on unrecaptured § 1250 gain 21
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