# CHAPTER 33 RECAPTURE OF DEPRECIATION

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CHAPTER 33

RECAPTURE OF DEPRECIATION

Problem 1:

The original basis of the boat is \$150,000. § 1012. Under the facts of the Problem, the § 179
deduction is \$100,000 (note that the dollar limitation in 2007 is actually \$125,000, but on the facts
John deducts only \$100,000 under § 179). § 179(a), (b)(1), (d)1). The Year 1 depreciation deduction
under § 168 is \$10,000 (5 year property, double declining balance method, half-year convention -
\$50,000 x .20). See Table 1 in the materials. Note that the percentages are applied to a \$50,000
adjusted basis. Thus, at the outset of Year 2, the adjusted basis in the boat is \$40,000. The Year 2
depreciation deduction is \$16,000, (i.e., \$50,000 x .32) producing an adjusted basis at the outset of
Year 3 of \$24,000. The depreciation allowed in Year 3 is \$4,800 (i.e.,50,000 x .192/2 — the
student must remember to apply the half-year convention in the year of disposition).
§ 168(d)(4)(A). Therefore, the adjusted basis of the property at the time of sale is \$19,200. Since
John sells the boat for \$165,000, the sale produces a gain of \$145,800.

Problem 1 also asks how the gain is characterized. It might be worth noting that the boat is
not a capital asset (§ 1221(2)), but it is property used in the trade or business as defined in
§ 1231(b)(1). The boat is depreciable personal property, so it constitutes "Section 1245 property."
§ 1245(a)(3)(A). Under § 1245(a)(1), the lower of recomputed basis or the amount realized on the
sale, less the adjusted basis of the property, is treated as ordinary income. The recomputed basis
here equals the adjusted basis of \$19,200 plus the prior depreciation deductions (including § 179
deductions) totaling \$130,800. (§ 1245(a)(2)(A), (C)) - in other words, the recomputed basis is equal
to the original basis of \$150,000. Since the recomputed basis is less than the amount realized, under
the "lower of" rule the gain that constitutes ordinary income under § 1245(a)(1) is \$130,800, the
amount of the previously taken depreciation deductions and § 179 deductions. The total gain, as
noted, was \$145,800. There is thus \$15,000 of gain that is not subject to § 1245(a)(1). That \$15,000
constitutes a § 1231 gain for the year, and depending on the outcome of the § 1231 hotchpot, it may
be characterized as long term capital gain. Regulation §§ 1.1245-6(a), 1.1245-1(b)(2) example 2.

Problem 2:

The gift of the boat to brother Bob does not trigger § 1245 recapture. § 1245(b)(1). It does,
however, trigger recapture under § 179. § 179(d)(10). Reg. § 1.179-1(e) provides: "If a taxpayer's
section 179 property is not used predominantly in a trade or business of the taxpayer at any time
before the end of the property's recovery period, the taxpayer must recapture in the taxable year in
which the section 179 property is not used predominantly in a trade or business any benefit derived

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from expensing such property." The "benefit" to be recaptured under § 179 is the excess (if any)
of the deduction taken under § 179 over the deductions that would have been taken anyway under
§ 168 with respect to the same amount. If the taxpayer had not elected § 179 (thus taking the
\$100,000 deduction thereunder), the § 168 deductions with respect to that \$100,000 would have
totaled \$61,600 (\$20,000 in Year 1, \$32,000 in Year 2, \$9,600 in Year 3). Thus, the "benefit" of
electing § 179 in this instance was the difference between \$100,000 and \$61,600, or \$38,400, which
is the amount John must include in income on disposition of the property. This amount will be
characterized as ordinary income. Reg. § 1.179-1(e)(1).

The amount that John includes in income is added to the basis of the boat. Reg.
§ 1.179-1(e)(3). Thus John’s adjusted basis in the boat at the time of his gift of the boat to Bob will
be \$57,600 (\$19,200 plus \$38,400.) Under § 1015, Bob’s basis in the boat is \$57,600. Since Bob
used the property for personal purposes, no depreciation deductions were allowable to Bob. On
Bob's sale of the boat for \$165,000, there is therefore a gain of \$107,400. The boat is still " Section
1245 property" since it is still of depreciable "character." § 1245(a)(3)(A). The recomputed basis
is once again \$150,000, since we must add to the adjusted basis those depreciation deductions
allowed to Bob or "to any other person" — i.e., John. § 1245(a)(2)(A). John, in effect, was allowed
a total of \$92,400 in depreciation deductions. Thus, as indicated, Bob’s recomputed basis is
\$150,000. Under the lower of rule, the amount that constitutes ordinary income is thus \$150,000
minus \$57,600, or \$92,400. The remaining \$15,000 of gain is not subject to § 1245(a)(1). Does this
\$15,000 of gain enter the § 1231 hotchpot? No. In Bob's hands this boat is apparently a capital asset
and the \$15,000 thus constitutes long term capital gain. (Note: Bob would be entitled to tack John’s
holding period. Thus, Bob will be deemed to have held the boat long term.)

Problem 3:

To begin with, one might note that John’s Year 3 depreciation deduction with respect to the
boat is the same as it was in Problem 1 - that is, for depreciation purposes, retiring the boat from
service is equivalent to selling it and the half year convention applies in both cases. See Rev. Proc.
87-57, 1987-2 C.B. 687, 691. Nonetheless, John's conversion of the boat to personal use is not a
"disposition" under § 1245(a)(1). See Rev. Rul. 69-487 in the text. So § 1245 does not apply to the
conversion. Section 179(d)(10), however, does apply once again and will once again produce
ordinary income to John of \$38,400. Since the recaptured income is reflected in basis, John's
adjusted basis following the conversion will be \$57,600. The adjusted basis will remain the same
thereafter since the property has been converted to personal use. When John later sells the boat for
\$100,000, there is a § 1245 disposition. Under the "lower of" rule, the lower of amount realized or
recomputed basis is the \$100,000 amount realized. Thus the ordinary income is \$100,000 minus
\$57,600, or \$42,400.

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Problem 4:

The apartment building is presumably residential rental property. §§ 168(e)(2)(A) and
167(j)(2)(B). The depreciation to be taken is straight line depreciation over 27-1/2 years, using the
mid-month convention. See Table 6 in the materials for Chapter 14. The apartment building does
not constitute § 179 property. The Year 1 depreciation deduction is \$33,340; the Year 2 deduction
is \$72,720; and the Year 3 deduction is \$3,030 (applying the mid-month convention in the year of
disposition). Thus, at the time of disposition, the adjusted basis of the property is \$1,890,910. When
the property is sold for \$2,500,000, there is thus a gain of \$609,090. The property is not "Section
1245 property", but it is "Section 1250 property." § 1250(c). Section 1250(a)(1) provides for the
recapture of the "applicable percentage" of the lower of "additional depreciation," or the excess of
amount realized on the sale over adjusted basis. Section 1250(a)(1)(A). The applicable percentage
here is 100%. § 1250(a)(1)(B)(v). The difference between amount realized and adjusted basis, as
noted above, is \$609,090. "Additional depreciation" is defined in § 1245(b)(1) as, essentially, the
depreciation adjustments in excess of straight line (with respect to that property held more than a
year). Additional depreciation is therefore zero, and applying the "lower of" rule the amount
recaptured is 100% of zero, or zero. None of the gain is subject to Section 1250 recapture. The
apartment building is property used in the trade or business with in the meaning of § 1231(b), and
thus all of the gain enters the § 1231 hotchpot where it may be characterized ultimately as long term
capital gain.

Problem 5:

We have the same gain as before, \$609,090. What is the character of the gain? Does
§ 1239(a) apply? There is a sale or exchange of depreciable property, so it is necessary to determine
whether John and ABC Corporation are "related persons." Section 1239(b)(1) defines related
persons as a person and all "controlled entities" with respect to such person. Section 1239(c)(1)(A)
defines a controlled entity, with respect to any person, as a corporation more than 50% of the
outstanding stock of which, by value, is owned directly or indirectly by or for such person.
Constructive ownership rules similar to the rules under § 267(c) — except for § 267(c)(3) — are
applicable. § 1239(c)(2). Does John own more than 50% of ABC Corporation under these rules?
(1) John owns 15% outright; (2) John is deemed to own the 30% of ABC Corporation that his
brother Bob owns. § 267(c)(2), (c)(4). (3) John is not treated as owning the 15% of ABC owned
by his niece Diane. An uncle and a niece are not "members of a family." § 267(c)(4). And there
is no double family attribution. § 267(c)(5). (4) Mary-Belle Corporation owns 40% of ABC
Corporation. John's wife Mary owns one-quarter of Mary-Belle Corporation. Mary is thus treated
as owning one-quarter of any stock owned by Mary-Belle Corporation. § 267(c)(1). As a result,
Mary is deemed to own 10% of ABC Corporation. John in turn is deemed to own the stock owned
by his wife Mary. § 267(c)(2), (c)(4). Double attribution is permissible under § 267(c)(5), because
the stock Mary is treated as owning under § 267(c)(1) is treated as actual ownership for purposes
of applying § 267(c)(2). See § 267(c)(5). John thus owns, constructively, 10% of ABC Corporation
by virtue of Mary-Belle Corporation's actual ownership of ABC stock. In conjunction with his

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outright ownership and the constructive ownership of 30% of ABC through brother Bob, John is
treated as owning 55% of ABC Corporation. Thus, on the sale of the apartment building by John
to ABC Corporation, ABC Corporation constitutes a controlled entity, with result that John and
ABC are related persons, and all of the gain recognized by John — not just the portion of the gain
attributable to depreciation deductions taken — constitutes ordinary income. (Note: Belle’s
constructive ownership of ABC will not be attributed to John. Belle is John’s sister-in-law, not a
member of his family under § 267, and double family attribution is not permitted.)

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