4797/6252 gains - order of recognition

[Snaggletooth]

The question deals with whether ordinary income portions are required to be recognized first in cases of sales of rental property. (or any property, I suppose)

The best way to ask the question is with a simplified example:
a) Selling Price $200,000
b) Original Basis $120,000
c) Accumulated Depreciation $30,000
d) Installment terms: $100,000 received in Year 1, $100,000 received in Year 2.

Gain is measured quite obviously as $110,000. $80,000 in capital gains, $30,000 in depreciation recapture.

Which of the following is true?
a) Half the gain $55,000 is reported in Year 1, $40,000 in LTCG and $15,000 in depreciation recapture. Year 2 reports the same thing: $40,000 in LTCG, $15,000 depreciation recapture.
b) Half the gain $55,000 is reported in Year 1, but the $30,000 in recapture has pre-emption, $25,000 as LTCG. Year 2 reports $55,000 ALL of which is LTCG.
c) $30,000 depreciation recapture is not eligible for installment. Year 1 reports $30,000 in depreciation recapture, and $40,000 in LTCG. Year 2 reports $40,000 in LTCG only.
d) Some other result.

Mr. Slugg, please allow me to call s. 1250 situation as "depreciation recapture" as most of us understand what this is.

[New York Enrolled Agent]

The question deals with whether ordinary income portions are required to be recognized first in cases of sales of rental property. (or any property, I suppose)

The best way to ask the question is with a simplified example:
a) Selling Price $200,000
b) Original Basis $120,000
c) Accumulated Depreciation $30,000
d) Installment terms: $100,000 received in Year 1, $100,000 received in Year 2.

Gain is measured quite obviously as $110,000. $80,000 in capital gains, $30,000 in depreciation recapture.

Which of the following is true?
a) Half the gain $55,000 is reported in Year 1, $40,000 in LTCG and $15,000 in depreciation recapture. Year 2 reports the same thing: $40,000 in LTCG, $15,000 depreciation recapture.
b) Half the gain $55,000 is reported in Year 1, but the $30,000 in recapture has pre-emption, $25,000 as LTCG. Year 2 reports $55,000 ALL of which is LTCG.
c) $30,000 depreciation recapture is not eligible for installment. Year 1 reports $30,000 in depreciation recapture, and $40,000 in LTCG. Year 2 reports $40,000 in LTCG only.
d) Some other result.

Mr. Slugg, please allow me to call s. 1250 situation as "depreciation recapture" as most of us understand what this is.

While not authority, look at page 6 of Pub 537

[Snaggletooth]

Answer - Thanks

Thanks for your direction. From the pub, it appears like the depreciation recapture is IMMEDIATELY recognized in full and is not eligible for installment treatment.

b) or c) appears to be the correct answer. As you say, the pub does not reference Code or Regs. The wording of the pub leans toward c) in my opinion but does not rule out b).

[Kram BergGold]

agree

from seminars I have taken over the years my remembrance is that depreciation has to be taken into consideration first when an installment sale occurs.

[New York Enrolled Agent]

Thanks for your direction. From the pub, it appears like the depreciation recapture is IMMEDIATELY recognized in full and is not eligible for installment treatment.

b) or c) appears to be the correct answer. As you say, the pub does not reference Code or Regs. The wording of the pub leans toward c) in my opinion but does not rule out b).

Try section 453(i) as an authority

[Roland Slugg]

Mr. Snagg, I have long ago given up in my futile effort to encourage you to refer to Unrecaptured §1250 Gain by its correct name. I can tell you with absolute certainty, however, that your dogged and stubborn insistence on referring to it as "depreciation recapture" is causing you to fail to understand the differences between the way Unrecaptured §1250 Gain is taxed and the way true "depreciation recapture" is taxed. Apparently, you read the reference in IRS Pub 537, and by now you may also have read NYEA's reference to Code §453(i), both of which refer to "depreciation recapture" and say that it is taxed in its entirety in the year of sale, even if the sale is reported on the installment basis. Both of those sources ... Pub 537 and Code §453(i) ... are, indeed, correct about that. And, of course, you saw the term "depreciation recapture" and, naturally equated it to the gain in the example you gave in your OP, because in that example you used that very same terminology. "Aha! There's my answer." There is only one teeny little problem with that ....

In the example you gave there is no "depreciation recapture." None. Zero. Nada. Zip.

Instead, there is $30,000 of Unrecaptured §1250 Gain.

When property is sold at a gain and reported on the installment method, the Unrecaptured §1250 Gain, if there is any, is reported first, until it is all reported, and then the rest of the "pure capital gain" portion is reported. If the gain reportable in the year if sale is less than the full amount of the Unrecaptured §1250 Gain, the rest of the Unrecaptured §1250 Gain will be reported in future years until it is all reported, at which time the character of the reportable gain will shift from Unrecaptured §1250 Gain to regular Capital Gain. For an authoritative cite on point, please see Regs §1.453-12(a).

Using the facts given in your example, Snagg, the answer to your original question is (b) ... although your terminology really sucks.

If the installments were going to be $20,000 (plus interest) per year for ten years, instead of $100,000 in each of two years, the gain would be reportable as follows:
Year 1 ... Reportable capital gain of $11,000 ($20,000 x 55%), of which all $11,000 is Unrecaptured §1250 Gain
Year 2 ... Reportable capital gain of $11,000, of which all $11,000 is Unrecaptured §1250 Gain
Year 3 ... Reportable capital gain of $11,000, of which all $8,000 is Unrecaptured §1250 Gain
Years 4 thru 10 ... Reportable capital gain of $11,000 each year, of which none is Unrecaptured §1250 Gain

I hope other visitors to this Board don't see your frequent references to "depreciation recapture" and equate it to "Unrecaptured §1250 Gain." The two concepts are entirely different, and the ways they are taxed are also very different. I have long believed that "Unrecaptured §1250 Gain" is one of the most misunderstood concepts in all the tax laws, and referring to it as "depreciation recapture" will only serve to strengthen and prolong those misunderstandings. For those whose understanding about this is a bit fuzzy, I will say that when depreciable real estate is sold, there is rarely, if ever, any depreciation recapture. When business equipment ... i.e. §1245 property ... is sold at a gain, there is almost always "depreciation recapture." On the other hand, when depreciable real property (held for more than one year) is sold at a gain there is always some "Unrecaptured §1250 Gain," but "depreciation recapture" is virtually nonexistent. In my own practice I have not seen a sale of real property that resulted in "depreciation recapture" in at least twenty years.

Finally, I was very surprised to see NYEA offer as authority Code §453(i). NYEA is usually spot-on, and I would speculate that even he was seduced by the references to "depreciation recapture."

[Snaggletooth]

Ordinary Income

I expected this.

Even the taxation of s.1250 "recapture" is at LTCG rates (with the exception of long-defunct ACRS). My example seemed to imply it is ordinary income. It is not, and even us numbskulls who call this "recapture" are aware of the difference in taxability.

The only reason I referred to ordinary income is because two years ago, my client had an "unrecaptured s. 1245 loss". I don't think my example went there because I didn't want to complicate the thought process of the reader.

Nonetheless, thank you for the time you spent on your well-thought-out response, which as I read it, believe to be absolutely correct. For the sage NYEA to be seduced by the terminology is equivalent to vernacular substitution of "Y'all come."

[JohnH]

I've printed this thread for future reference. Sure wish this conversation had taken place a couple of months ago - it would have saved me hours of reading. making notes, and second-guessing myself. In any event, many thanks to everyone for their input. Or, as we say in NC, "Bless all-yall's hearts."

[JON]

1245 recapture is not available for installment gain treatment! If software (tax depreciation) is used they will do it correctly, but each as limitations on how to record the individual sales in the proper categories(mass assets) and they cannot be combined into one sale. Covenant to compete(s) included in a note makes it all taxable immediately in my book.

[Snaggletooth]

What is available for installment treatment?

1245 recapture is not available for installment gain treatment!

Of course not. It is immediately reported as a 4797 item of income. That's why I didn't want to complicate things.

Jon, what would your answer be to the original question, b) or c)? Both are LTCG, but does the formula divide the total gain by two and back out the s.1250 recapture? Or does it back out the s.1250 first and THEN divide the remainder by two?

[Roland Slugg]

Two years ago, my client had an "unrecaptured s. 1245 loss". I don't think my example went there because I didn't want to complicate the thought process of the reader.

That is quite understandable.

The correct name for the prior year loss to which you now refer is: "Nonrecaptured net section 1231 loss" (not "unrecaptured s. 1245 loss"). This refers to net §1231 losses that were deducted in the five years prior to the current year and that have not been offset by a net §1231 gain in an intervening tax year.

In your client's case, this will have the effect of changing all or a portion of the capital gain reportable in the year of sale into an ordinary gain, up to the amount of that §1231 loss he reported two years ago. The good news is that the unrecaptured §1250 gain arising from the current year's sale will be the first to be absorbed by his nonrecaptured net §1231 loss. So depending on how much that prior year loss was, the net effect on your client's current year's tax could be very little or even none at all.

To report the sale on his tax return, first complete F-6252, Installment Sale, then enter the current year's taxable gain on F-4797, line 4. Assuming there are no entries on lines 5 or 6, this same amount will then appear on F-4797, line 7. Next enter the T/P's nonrecaptured net section 1231 loss on line 8, and finally enter the smaller of line 7 or line 8 on F-4797, line 12. This is the ordinary income portion of the current year's gain. The rest of the current year's gain, if any, is capital gain. There may still be some amount of unrecaptured §1250 gain, depending on how much of the current year's gain was treated as ordinary income because of the nonrecaptured net §1231 loss rules.

There are tax planning opportunities whenever a client has a fact pattern similar to the one you have used in your original and second posts. If an installment sale can be arranged so that very little gain will be recognized during the 5-year period following a large §1231 (ordinary) loss, that strategy will minimize the effect of the nonrecaptured net §1231 loss rules. On the other hand, the unrecaptured §1250 gain rules may end up having the same, or a similar net effect anyway.