Recapture

The practical significance for exchange practice is narrower than the length of these statutes suggests, and it runs in a direction most clients do not anticipate. A fully deferred exchange triggers no recapture. An exchange with boot may convert the entire recognized amount into ordinary income or into gain taxed at twenty five percent. And what is not triggered is not forgiven; it migrates into the replacement property and accumulates across a chain of exchanges.

37.1 Section 1245 recapture in an exchange

The operative rule is uncompromising on its face. If section 1245 property is disposed of, the amount by which the lower of the recomputed basis of the property or, in the case of a sale, exchange, or involuntary conversion, the amount realized, exceeds the adjusted basis of the property is treated as ordinary income. Such gain "shall be recognized notwithstanding any other provision of this subtitle."¹

That final clause is the override. Section 1245 does not yield to section 1031 by operation of general principle; it yields only where an express exception applies.

Recomputed basis means the adjusted basis of the property recomputed by adding all adjustments reflected in that adjusted basis on account of deductions for depreciation or amortization allowed or allowable to the taxpayer or to any other person.² Deductions under section 179 and a list of related provisions are treated as amortization for this purpose.³

Section 1245 property is property that is or has been of a character subject to the depreciation allowance and is either personal property; certain other tangible property, not including a building or its structural components, used as an integral part of manufacturing, production, extraction, or the furnishing of listed services, or constituting a research or bulk storage facility; so much of any real property as has an adjusted basis reflecting amortization adjustments under an enumerated list of provisions; a single purpose agricultural or horticultural structure; or a storage facility.⁴

The exception for like-kind exchanges is the provision examined at 33.4. If property is disposed of and gain, determined without regard to section 1245, is not recognized in whole or in part under section 1031, the amount of gain taken into account as recapture shall not exceed the sum of the gain recognized on the disposition, determined without regard to section 1245, plus the fair market value of property acquired which is not section 1245 property and which is not taken into account under the first component.⁵

Where section 1245 property arises in a real property exchange. After 2017 personal property is not eligible for nonrecognition at all, so most section 1245 property in a transaction is simply non-qualifying property, disposed of in a taxable sale with recapture applying to it in full. The categories that still appear on the real property side of an exchange are components identified by a cost segregation study, land improvements amortized under one of the enumerated provisions, single purpose agricultural or horticultural structures, and storage facilities.

Recapture potential migrates. The adjustments reflected in adjusted basis that must be taken into account in determining recomputed basis are not limited to adjustments with respect to the property disposed of, nor to adjustments allowed to the taxpayer disposing of it. All such adjustments are taken into account, whether the deductions were allowed in respect of the same or other property and whether to the taxpayer or to any other person.⁶

The regulation illustrates the point through a chain that includes a gift and then a like-kind exchange, and computes the recomputed basis of the replacement property by adding back depreciation deducted by the prior owner on the original property, depreciation deducted by the taxpayer on the relinquished property, and depreciation deducted on the replacement property itself.⁷

Recapture deferred in an exchange is therefore carried forward in the recomputed basis of what the taxpayer acquires. Nothing is extinguished.

37.2 Section 1250 recapture and unrecaptured section 1250 gain

Section 1250 property means any real property, other than section 1245 property, which is or has been of a character subject to the depreciation allowance.⁸ Nearly every building in an exchange is section 1250 property.

The recapture rule is structurally parallel to section 1245 and, for modern property, almost never applies. If section 1250 property is disposed of, the applicable percentage of the lower of the additional depreciation attributable to periods after 1975 or the excess of the amount realized over the adjusted basis is treated as ordinary income, recognized notwithstanding any other provision.⁹

Everything turns on the definition of additional depreciation. The term means the depreciation adjustments in respect of the property, except that in the case of property held more than one year it means those adjustments only to the extent they exceed the adjustments that would have resulted under the straight line method.¹⁰

Real property placed in service after 1986 is depreciated straight line under MACRS. There is accordingly no additional depreciation, and section 1250 recapture on such property is zero. The provision remains on the books, matters for property placed in service under earlier regimes, and can be encountered on a component amortized under an accelerated method, but for the ordinary building acquired in the last four decades it is a dead letter.

A like-kind exchange limitation parallels the section 1245 rule, expressed as the greater of the gain recognized on the disposition, increased as the statute provides, and an amount computed where insufficient section 1250 property is acquired.¹¹

What survives is not recapture at all. Unrecaptured section 1250 gain is a rate category rather than a character rule, and it is where the tax on a depreciated building actually lives.

The term means the excess of the amount of long-term capital gain, not otherwise treated as ordinary income, which would be treated as ordinary income if section 1250(b)(1) included all depreciation and the applicable percentage under section 1250(a) were one hundred percent, over the netting amounts the statute specifies.¹² The definition is a hypothetical: compute section 1250 recapture as if straight line depreciation counted and the percentage were complete, and the result is the unrecaptured amount.

That amount is taxed at twenty five percent.¹³ It is capital gain, not ordinary income, but it is not taxed at the rate a client means when saying capital gain.

One limitation applies where the property is used in a trade or business. The amount from sales, exchanges, and conversions described in section 1231(a)(3)(A) for any taxable year may not exceed the net section 1231 gain for that year.¹⁴

For a building held twenty years and depreciated straight line, the unrecaptured section 1250 gain is the whole of the accumulated depreciation, subject to the ceiling of gain actually present. That figure is usually the largest single component of the tax on a disposition, and it is fully deferred in a qualifying exchange.

37.3 The recapture-triggering effect of boot

Both recapture provisions are capped by the gain recognized without regard to them.¹⁵ The first consequence is favorable and should be stated plainly: a fully deferred exchange, with no boot and no recognized gain, triggers no recapture of any kind.

Where boot is received, the recognized gain computed under Chapter 33 must be characterized, and the ordering is fixed by the statutes themselves. Because both provisions direct that the gain they describe be recognized notwithstanding any other provision, recapture is taken first out of the recognized amount.

For a real property exchange with boot, the recognized gain is composed in this order:

Section 1245 ordinary income, to the extent of recapture potential in any section 1245 property involved, subject to its own ceiling.

Section 1250 ordinary income, which for property placed in service after 1986 is ordinarily zero.

Unrecaptured section 1250 gain, taxed at twenty five percent, to the extent of accumulated straight line depreciation.

Long term capital gain, taxed at the taxpayer's applicable rate, on whatever remains.

The arithmetic consequence is the reason this chapter matters to a client conversation rather than to a return preparer. Consider a building held twenty years with $600,000 of accumulated straight line depreciation, exchanged in a transaction producing $100,000 of boot. The entire $100,000 falls within the unrecaptured section 1250 gain layer and is taxed at twenty five percent. None of it reaches the twenty percent rate, and none of it reaches fifteen. Add the net investment income tax where it applies, and State income tax, and the effective rate on that $100,000 may exceed thirty percent.

The client who asked to take $100,000 out of the exchange and was told it would be taxed at capital gain rates was told something misleading. The rate on boot should be computed from the depreciation schedule before the client decides, and the computation takes minutes.

A second consequence is structural. The recapture and twenty five percent potential that boot does not trigger is not forgiven. It carries into the replacement property, which is the subject of 37.4.

37.4 Recapture on the eventual taxable disposition

An exchange defers the character of gain as well as its amount, and the mechanism is the same substituted basis that produced the deferral.

For section 1245 property, the recomputed basis of the replacement property includes every depreciation adjustment reflected in its adjusted basis, which by operation of the substituted basis rule includes adjustments attributable to the relinquished property and to property held by prior owners in the chain.¹⁶

For unrecaptured section 1250 gain, the result follows from the definition. Because the amount is measured by a hypothetical in which section 1250(b)(1) included all depreciation,¹⁷ and because the replacement property's adjusted basis reflects the depreciation taken on the relinquished property through the substituted basis computation of Chapter 35, the accumulated depreciation of the entire chain is present when the replacement property is eventually sold.

The accumulation problem. A taxpayer who exchanges repeatedly builds a replacement property carrying the depreciation history of every property that preceded it. The final taxable disposition produces a tax that bears no relation to the last property's own holding period or its own depreciation, and clients routinely find the number incomprehensible when it arrives.

Two exits exist and there is no third.

The basis adjustment at death eliminates the deferred gain, including its recapture and twenty five percent components, because the successor takes a basis equal to fair market value and the depreciation history is not reflected in it. That sequence, and the policy critique of it, is developed at 46.1 and at 3.5.

A taxable disposition pays the accumulated tax in one year, at the composite rate described in 37.3 applied to the whole chain.

The record-keeping obligation follows directly, and it is the most commonly failed documentary duty in exchange practice. Establishing the basis and depreciation history of a replacement property requires the Form 8824 for every exchange in the chain, the settlement statements for each disposition and acquisition, the depreciation schedules for each property, and the allocations between land and improvements made at each acquisition. That file must survive decades, changes of accountant, entity restructurings, and in many cases the death of the person who understood it.

Counsel should say so at the first exchange, in writing, and should tell the client where the file will live. A taxpayer who cannot substantiate basis bears the burden of proof on it.

One further characterization rule can convert capital gain to ordinary income independently of recapture. Gain on the disposition of real property used in a trade or business is section 1231 gain. Where section 1231 gains exceed section 1231 losses for the year, they are treated as long term capital gains.¹⁸ But net section 1231 gain is treated as ordinary income to the extent it does not exceed the non-recaptured net section 1231 losses, meaning the aggregate net section 1231 losses for the five most recent preceding taxable years, reduced by amounts already taken into account.¹⁹

A taxpayer who recognized section 1231 losses within the last five years will therefore find recognized boot gain characterized as ordinary income before any capital rate is reached. The five year lookback is a component of the rate computation that is easy to omit and is knowable from the prior returns.