Section 1245 is a crucial part of the Internal Revenue Code (IRC) that outlines the tax rates applicable to gains from the sale or transfer of depreciable and amortizable property. It particularly pertains to specific types of real or tangible business property held for more than 12 months. This provision ensures that gains are taxed at the ordinary income rate rather than the lower capital gains rate under certain conditions.
Key Takeaways
- Tax Recapture Mechanism: Section 1245 allows the IRS to recapture allowable or allowed depreciation or amortization on 1231 property when sold at a gain.
- Applicable Gains: This recapture occurs when a business sells certain tangible or intangible personal property at a profit.
- 1231 vs. 1245: Section 1231 provides a favorable tax treatment by applying a lower capital gains rate on profits and a higher ordinary income rate on losses.
- Depreciation Effect: If a business has claimed depreciation deductions on its property and later sells it for a gain, Section 1245 recaptures the depreciation at ordinary income tax rates.
Delving Into Section 1245
Section 1245 targets the recapture of depreciation or amortization allowed on tangible and intangible personal property upon their sale by a business. The gain is taxed at ordinary income rates to the extent of its allowable or allowed depreciation or amortization.
What Qualifies as Section 1245 Property?
The IRS defines Section 1245 property as:
Section 1245 properties must undergo an allowance for depreciation or amortization. They can be either personal property (tangible or intangible) or other tangible property (excluding buildings and structural components) utilized as any of the following:
- An integral part of manufacturing, production, or extraction processes, or in providing transportation, communication, electricity, gas, water, or sewage disposal services.
- A research facility in any of the aforementioned activities.
- A facility used in these activities for the bulk storage of fungible commodities.
Recapture Feature of Section 1245
Section 1245 provides a mechanism to recapture at ordinary income tax rates, the allowable or allowed depreciation or amortization taken on Section 1231 property. The amount recaptured is the larger of the depreciation or amortization claimed or that which could have been claimed.
a Section 1231 property refers to real or depreciable business property held for more than a year.
A Historical Perspective of Section 1245
The primary concept is that a lower tax rate on gains translates to reduced taxes payable, while a higher tax rate on losses results in a larger offset of taxable income and lower taxes payable. Tax strategies aim to achieve lower capital gains rates for gains and higher ordinary income rates for losses.
Congress introduced IRC Section 1231 to benefit businesses by allowing a lower capital gains rate on profits and a higher ordinary income rate on losses from the sale of property. Nonetheless, many businesses had previously benefited from taking depreciation or amortization deductions on these properties. To address this, Congress enacted Section 1245 for recapturing depreciation and amortization at ordinary income rates on properties sold at a gain.
a Reading of Section 1245 illustrates that it encompasses newly defined property—Section 1245 property.vi However, it essentially refers to Section 1231 property that has been depreciated or amortized. Section 1245 property remains such only as long as it retains unrecaptured depreciation or amortization. Once fully recaptured, it transitions back to Section 1231 property.
Tax Considerations When Selling Section 1245 Property
When a business sells Section 1245 property at a loss, it effectively converts into Section 1231 property for tax purposes, and the loss is considered ordinary. However, if sold at a gain, it remains Section 1245 property. The gain amounts corresponding to depreciation or amortization are taxed at ordinary income rates.
Once all depreciation or amortization is recaptured, the property transitions into Section 1231 property, and any remaining gain is taxed at capital gains rates.
Exemplary Sale of Section 1245 Property
Consider a business that owns an asset worth $100 and depreciates it by $75, leaving an adjusted tax basis of $25. Upon selling the asset for $150:
The gain is $150 (sell price) minus $25 (adjusted tax basis), which equals $125. Of this $125 gain, $75 (representing the depreciated amount) is a Section 1245 gain, taxed at ordinary income rates. The remaining $50 is a Section 1231 gain, taxed at capital gains rates.
However, if that asset sells for $20, there is a $5 loss (sale price minus the adjusted tax basis). As there is no gain, Section 1245 does not apply, making the loss a Section 1231 loss treated as an ordinary loss.
The Distinction Between Section 1245 Property and Section 1231 Property
Section 1245 and Section 1231 deal with similar types of business property; the main difference lies in the depreciation or amortization status. Section 1245 property has undergone depreciation or amortization, and once fully recaptured, it becomes Section 1231 property.
Conclusion
Section 1245 provides a structured way for tax authorities to recapture taxes on Section 1231 property that has undergone depreciation or amortization. It chiefly pertains to real or depreciable business property retained for more than one year. Depreciation or amortization is recaptured at the point of sale, subjecting the gain to ordinary income tax rates. Following full recapture, the property transitions to be treated under Section 1231, with the remaining gains taxed at capital gains rates.
Related Terms: Section 1231, Amortization, Depreciation Recapture, Capital Gains Tax, Ordinary Income Tax.
References
- Internal Revenue Service. “Publication 544: Sales and Other Disposition of Assets”, Page 26-27.
- Internal Revenue Service. “Publication 544, Sales and Other Dispositions of Assets”.
- Internal Revenue Service. “IRS Provides Tax Inflation Adjustments for Tax Year 2024”.
- Internal Revenue Service. “Tax Topic No. 409, Capital Gains and Losses”.
