Welcome back. Recall that in the last several videos, our goal has been to properly identify the character of gains and losses that result from property transactions. At a high level, the type of asset that sold determines the character of the gain or loss on that sale. In particular, we learned that there are three types of assets. First, ordinary assets are used in a trade or business and held for one year or less. Two major examples here are inventory and accounts receivable. That is when we sell inventory for more than what we bought it for that income is ordinary income tax at ordinary tax rates. It's essentially sales income. Second, capital assets are assets held for investment, the production of income or personal use. These are items like stocks, bonds, and other personal assets like a personal car. If we saw these assets and they're held long-term or greater than one year, we'll receive preferential tax rate treatment. If they're held short-term or one year or less, capital gains will be taxed at ordinary rates, while any net capital losses will be limited to a $3,000 for AGI deduction per year. Third, Section 1231 assets. Section 1231 assets represent real or depreciable personal property that's used in a trade or business and must be held for more than one year. That is, these are by definition long-term assets. The general tax treatment here is the gains from the sale of a Section 1231 asset, are ultimately tax at the long-term capital gains rate of 0, 15, or 20 percent, while losses are fully deductible against ordinary income. So again, Section 1231 assets have the best of both roles. Gains are lightly taxed while losses are fully and immediately deductible. In this video, we'll dig a bit deeper into some more issues surrounding character of Section 1231 gains by examining what is known as depreciation recapture. So first, what do we mean when we say depreciation recapture? This refers to a re-characterization of income. Basically, we re-characterized gains but not losses on the sale of Section 1231 assets. The computation of this depreciation recapture depends on the type of Section 1231 assets sold. Because this is a reclassification exercise, the depreciation recapture only changes the character but not the amount of gain recognized on the sale of the asset. This is at a high level similar to how Section 1231 look-back losses work. Recall that when we use look-back losses, we did not change the total amount of gain recognized on the sale of Section 1231 assets. They only changed the character or of some or all of the gain to ordinary income, such that the gains are not eligible for preferential 0, 15, 20 percent long-term capital gains rates. So here just to be clear we're only looking at Section 1231 assets, not at ordinary assets and not a capital assets. In order to properly identify the type of depreciation re-capture we must calculate if any, it's very important to know that there are actually three types of Section 1231 assets. Recall the Section 1231 assets or long-term business use realty, whether it's depreciable or not depreciable, and long-term depreciable personalty. So the first type of Section 1231 asset is a pure Section 1231 asset. A great example here is land. If it's used for business and held long-term, it's a Section 1231 asset. However, it will not be subject to any depreciation recapture because land is not depreciable in the first place. It's non depreciable realty. The second type of Section 1231 asset is known as a Section 1245 asset. This is depreciable personalty and intangibles used in a trade or business and held long-term. Here because we're dealing with depreciable personalty, we'll need to worry about depreciation re-capture. Finally, the third type of Section 1231 asset is known as a Section 1250 asset. This is depreciable realty use and trade business and held long term. Again, because we're dealing with depreciable realty, we will need to worry about depreciation recapture. So in all we have Section 1245 recapture and Section 1250 recapture. Let's just focus on section 1245 recapture right now. We'll look at Section 1250 in a later video. So what Section 1245 depreciation recapture does is that to the extent there's a gain on the sale of section 1245 property. The gain will be ordinary in character to the extent the gain was created by depreciation or amortization. Recall that realized gain equals the amount realized minus the adjusted basis or the adjusted basis is the difference between the original basis and the accumulated cost recovery. You can see here in the formula that to the extent an asset has been depreciated, it will by definition make the adjusted basis lower, which makes any gains larger. Remember, when a business claims depreciation deductions, the business receives an ordinary tax deduction. That is the deduction can offset ordinary income without limit. Therefore, to the extent that business sells section 1245 property, and the gain is there because depreciation depressed the adjusted basis to help create the gain, then the portion of the gain that's there because of the depreciation will not be subject to preferential tax rates, but instead, will be recaptured and taxed at ordinary tax rates. Therefore, the Section 1245 depreciation recapture is calculated as the smaller of the gain recognized or all the accumulated depreciation claimed on the sold property, which includes any straight line depreciation, accelerated depreciation like makers, as well as bonus in Section 179 depreciation elections. This lesser amount is recapture or re-characterized as ordinary income. This is known as a full recapture because any and all of the depreciation that drove the gain will be taxed at ordinary rates now, even though you're technically selling a Section 1231 asset at a gain and we're expecting to get preferential tax rate treatment. Put a different way, because the depreciation originally gave the taxpayer ordinary deduction treatment, then any gains that are there due to depreciation depressing the adjusted basis will now be ordinary income. This recapture tries to impose some symmetry on the tax system, in that a taxpayer can't simply generate preferential tax rates on selling Section 1245 assets and a gain just by depreciating these assets. This would in effect, from an economic standpoint, be value enhancing activities for the company to simply buy depreciable property, depreciate it and get ordinary deductions, and then sell at a gain which is taxed a preferential rates. The government would essentially lose out. Now, to the extent any gain a taxpayer recognizes is greater than the accumulated depreciation on the asset, then the remaining net gain is indeed a Section 1231 gain taxed at the 0, 15, or 20 percent preferential tax rate. Finally, there is no depreciation recapture on Section 1231 assets sold at a loss. If a Section 1231 asset is sold at a loss, then it's just a regular Section 1231 loss. Which assuming that survives after being netted with any other 1231 items will be fully and immediately deductible against ordinary income. So there's no recapture issue to worry about in a loss scenario. Probably an easier way to see some of these issues, is to show you some very basic pictures. In our first example, let's say you sell your Section 1245 property, maybe a business machine that you've held long-term, for more than the original cost. So when you bought the asset you paid some amount and this became your original cost. Overtime, you depreciated that property, and at the time of the sale you report a particular adjusted basis. Then you sell the asset at selling price one. What's the total gain here? Well, the total gain is simply the selling price minus the adjusted basis. So that's the yellow and blue boxes here. However, a part of that gain is there because you depreciated the asset in the first place. This accumulated depreciation appears in the blue box. Therefore the difference between the original cost and the adjusted basis in blue, will be recaptured under Section 1245 as ordinary income. While the part of the gain that represents the difference between the sales price and the original cost in yellow here, will be a true Section 1231 gain taxed at zero, 15 or 20 per cent. Just to check. Our calculation says that the Section 1245 recapture is the smaller of the gain recognized, or the yellow and blue boxes, or the accumulated depreciation. So just the blue box. In this case, the smaller amount is the accumulated depreciation, the blue box. Thus in this case, we'll recapture all of the depreciation that was claimed over the life of the asset as ordinary income when we sell the Section 1245 property at a gain. Now what happens if a sales price is smaller than the original cost, but bigger than the adjusted basis? Again, when we bought the asset we paid some amount and this became original cost. Over time we depreciated that property, and at the time of sale we reported a particular adjusted basis. Then we sold the asset at selling price two. What's the total gain here? Well, the total gain is simply the selling price minus the adjusted basis. So that's just the blue box in this case. The accumulated depreciation however, is the difference between the original cost and the adjusted basis, or both the blue and orange boxes. So our calculation says that the Section 1245 recapture is the smaller of the gain recognized, or blue box only, or the accumulated depreciation. The blue and orange boxes. In this case, the smaller amount is simply the gain, the blue part. Thus we will recapture the entire gain as ordinary income when we sell the Section 1245 property at a gain. There is no true Section 1231 gain here. Because we did not sell the asset for more than the original cost, like we did in the last example. In our third example, let's say our selling price is below our adjusted basis. So what happens now? Well again, when we bought the asset, we paid some amount in this became our original cost. Over time we depreciated the property and at the time of sale we reported a particular adjusted basis. Then we sold the asset at selling price three. Well here because we're selling the asset for less than the adjusted basis, we actually have a loss. Because we have a loss there is no depreciation recapture issue here. We only worry about recapture if there's a gain. Therefore with this loss, it's simply a Section 1231 loss, and it's an ordinary loss that is fully and immediately deductible against ordinary income. Let's look at a numerical example regarding Section 1245 depreciation recapture. Let's say Smith Company sells a machine with an adjusted basis of $6,000 for $10,000. Depreciation that was taken on this machine amongst the $2,500. What is the amount of gain that is recaptured as ordinary, and what amount is classified as Section 1231 gain if any? First, we need to figure out whether there's a gain or loss in the first place. To do that, we simply take the sales price, or the amount realized of $10,000 and subtract out the adjusted basis of $6,000. This gives us a realized gain of $4,000. Assuming that the realized gain is also the recognized gain, how much of this $4,000 is characterized as ordinary gain, and how much is characterized as a Section 1231 gain? Well, we know that Section 1245 depreciation recapture represents the gain due to depreciation. Here the depreciation taken was $2,500. More formally, the Section 1245 depreciation recapture, is the lesser of the recognized gain of $4,000, or the accumulated depreciation of $2,500. Therefore $2,500 of the $4,000 gain is characterized as ordinary income. So we recapture $2,500, but the total gain is $4,000. What happens to that extra $1,500 that was not recaptured? Well, to the extent that recognized gain is not represented by the accumulated depreciation, the gain is a true Section 1231 gain. In all the recaptured portion of the gain will be taxed at ordinary tax rates. While the Section 1231 gain would eventually be subject to the zero, 15, 20 percent preferential tax rates assuming there are no other Section 1231 assets, bought or sold during the year to net this amount with. If we want to see these points in our netting map, here's what we had before. Lots of words of course, but let's zoom in on the leftmost Section 1231 column, and the rightmost ordinary income column. You can see that on the left side the net 1231 gain that survives any look-back losses, and in fact, whether the gains survives any depreciation recapture as well will be moved to the zero, 15, 20 percent long-term capital gain column. If there is a net 12-31 loss, we just move it to the ordinary column. We don't have to worry about depreciation recapture at all. Then, as you look at the rightmost column, you can see that Section 1245 recaptured gains go directly into the ordinary income column. We actually do not place it in the 1231 column first. The Section 1245 recaptured amount goes right in the ordinary column as income. In summary, this video looked at a specific type of Section 1231 asset. Namely, a Section 1245 asset that refers to depreciable personalty used in a trade or business, and how long-term. The Section 1245 depreciation recapture is calculated as the lesser of any gain recognized on the sale of the asset, or the accumulated depreciation taken over the life of the asset. This recapture reclassifies the Section 1231 gain as ordinary income. Meanwhile, any remaining gain that is not subject to recapture is characterized as a Section 1231 gain. Eventually subject to the zero, 15, 20 percent tax rates. Finally, there is no depreciation recapture, when Section 1245 assets are sold at a loss. The loss would be a regular Section 1231 loss.
