Real Estate Depreciation Recapture

Philip Skalka, TC Summ. Op. 2003-107, serves as a reminder that not all real estate depreciation recapture by individual taxpayers is taxable at the 25% rate enacted by the Taxpayer Relief Act of 1997 (TRA 97). The Tax Court reiterated that Sec. 1250 gain recapture on a sale or exchange of real property is still ordinary income.

Background

Under Sec. 1250(c), Sec. 1250 property is any real property subject to the allowance for depreciation that is not Sec. 1245 property. For property held more than one year, gain realized on the disposition of Sec. 1250 property is recaptured as ordinary income, to the extent that the depreciation allowed or allowable exceeds the depreciation that would have resulted under the straight-line method; see Sec. 1250(a) and (b). Under Sec. 1250(a)(1)(A), Sec. 1250 gain is recognized as ordinary income, notwithstanding any other provisions of subtitle A of the Code.

According to the Tax Court in Skalka, the TRA 97 amended Sec. 1(h) to include Sec. 1(h)(1)(B) (current Sec. 1(h)(1)(D)), which taxes unrecaptured Sec. 1250 gain at a 25% capital gain rate. Sec. 1(h)(6)(A) defines unrecaptured Sec. 1250 gain as the amount of long-term capital gain that would be treated as ordinary income if Sec. 1250(b)(1) included all depreciation (i.e., all depreciation allowed or allowable on the property).

The unrecaptured Sec. 1250 gain definition in the TRA 97 would appear to effectively eliminate any Sec. 1250 gain being recaptured as ordinary income, because all the depreciation is deemed unrecaptured Sec. 1250 gain, taxed at 25%. However, because the Sec. 1250 gain rules apply notwithstanding any other provisions of Subtitle A of the Code and Sec. 1(h) is included in Subtitle A, the Sec. 1(h)(6)(A) definition of unrecaptured gain cannot override the Sec. 1250(a) ordinary income treatment of Sec. 1250 gain recapture.

Recognizing this conflict, Congress included technical corrections in the Internal Revenue Service Restructuring and Reform Act of 1998 (IRSRRA 98) that revised and clarified the definition of unrecaptured Sec. 1250 gain under the TRA 97. Under the IRSRRA 98, the definition of unrecaptured Sec. 1250 gain in Sec. 1(h)(6)(A) was amended to include long-term capital gain not otherwise treated as ordinary income. Under Section 6024 of the IRSRRA 98, the amendment took effect as if included in the TRA 97.

Current Issues

Although most post-1986 residential rental and commercial (i.e., nonresidential rental) real property is required under the modified accelerated cost recovery system (MACRS) to use straight-line depreciation, there are still many situations in which the Sec. 1250 ordinary income rules would apply.

Under the pre-ACRS rules, certain types of residential rental property were eligible to use accelerated depreciation methods. If these properties were put into service in the mid-to-late 1970s and used a common depreciable life of 30 years, there would currently be potential Sec. 1250 gain recapture.

ACRS residential rental property placed into service in 1985 or 1986 using the normal ACRS accelerated method would have excess depreciation over straight-line until the property is fully depreciated in 2003 or 2004, respectively, depending on whether it was 18- or 19-year recovery property; see Exhibit 1. This potential Sec. 1250 gain recapture will no longer apply for years after 2004, as all ACRS property will be fully depreciated.

ACRS commercial property for which a straight-line election was not made will be subject to ordinary income recapture. Unlike ACRS residential rental property, the cumulative excess-over-straight-line rule does not apply. Instead, the recapture will occur on all the depreciation taken. Thus, this recapture potential (absent a basis step-up under Sec. 1014 at the taxpayers death) will generally continue to be a problem indefinitely. Although the depreciation recapture in this case technically occurs under Sec. 1245, not Sec. 1250, the end result (ordinary income recapture) does not change; see Sec. 1245(a)(5)(C) as in effect before its repeal by the Tax Reform Act of 1986.

Certain MACRS assets that are Sec. 1250 property (such as land improvements), depreciated using the normal MACRS recovery method of 150% declining balance, will be subject to some ordinary income recapture until they are fully depreciated.

Under Sec. 168(k), certain qualified leasehold improvement property may be eligible for bonus depreciation deductions. Improvements deemed to be real property would be Sec. 1250 property and would appear to meet the recapture rules, as the bonus depreciation deductions would exceed those allowed under the straight-line method.

Summary

Recaptured Sec. 1250 gain will continue to be ordinary income; recapture will apply to real property with cumulative depreciation taken in excess of that allowed under the straight-line method. In addition, all depreciation taken on ACRS commercial real property will be recaptured at ordinary rates under Sec. 1245. When reporting a sale or exchange of real property, tax advisers should ensure that the tax on the gain is properly computed; it appears most tax-processing software programs do not automatically perform these calculations.

From Curt J. Welker, CPA, PKF San Diego, San Diego, CA