Multiple Choice

[Snaggletooth]

Mortimer sells a commercial building for $800,000. His original basis was $1,000,000, and over the years has taken $400,000 depreciation. All depreciation has been straight-line, and free of bonus depreciation, short life, i.e. no "accelerated" depreciation.

Terms of the sale are $100,000 per year in principal payments, and 7% interest is payable in addition to the principle. The amount of interest each year declines, so the payment itself actually declines, but the payment of $100,000 is constant, thus the loan is completely paid off in 8 years.

Mortimer may report as follows:

1) $200,000 LTCG in the year of sale and interest as received.
2) $25,000 LTCG each year for next 8 years, and interest as received.
3) $200,000 Ordinary recapture in the year of sale and interest as received.
4) $25,000 Ordinary recapture each year for next 8 years and interest as received.

If you feel neither of these is correct, add another choice...

[DonPriebe]

OK - I'll take the risk of being first and/or wrong.

Answer is 2 or optionally 1.

Property has an adjusted basis of $600K ($1000K purchase less $400K depreciation) and a sales price of $800K. Profit is $200K. Commercial building is 1250 property depreciated straight line with no extras, so depreciation recapture is -zero-. Entire $200K can be reported as received over 8 years on form 6252, or optionally in total in the year of sale.

[OldJack]

Agree with Don.. Answer is 2 or 1 is the normal, but...

Actually it could be "all of the above" if there are unrecaptured §1231 prior 5 year ordinary losses on line 8 that exceed $200,000 as the gain reported, by option 2 or 1, would end up as ordinary gain due to the recapture.

Further comment:

This gain is reported on ($200,000 option 1) or flows to ($25,000 option 2) form 4797 where it is subject to ordinary income if there have been ordinary 1231 losses unrecaptured in the past 5 years.

If the gain on form 4797 is not treated as ordinary income as a result of line 8, it is then capital gain for schedule D at a max tax rate of 25%.

[Snaggletooth]

Section 1245 stuff

Actually, this question is very close to a sale I'm working on as we speak, to be consummated on Jan 1, 2007.

Old Jack, inside this building (and included in the numbers) is about $20,000 of Section 1245 stuff, with some $15,000 depreciation taken. I didn't include it in the question because I didn't want to receive confusing answers.

It's reassuring to know both you and Don confirm what my answer would be. However, with the respect to the immediate recapture of the 1245 stuff, is the TOTAL gain prorated amongst 8 years and $15,000 of the $25,000 recaptured immediately, OR is the $15,000 recaptured immediately, leaving $185,000 spread over the 8 year period?

Let me ask the question another way, via illustration:

1. Year 1 Total Gain $25,000 with $15,000 ordinary and $10,000 LTCG.
Then Years 2-8 LTCG $25,000 in each year.

OR

2. Year 1 Ordinary recapture $15,000, LTCG $23,125
Then Years 2-8 LTCG $23,125 in each year.

This question may require much more thought than my original post, which wasn't really very tough for experienced tax pros.

[OldJack]

The simplest way to explain and handle this is to think in terms of separating the sale of §1245 property as it should not be a part of the installment sale for "tax reporting" purposes with the real estate. I would have to look at the installment sale form, but I think it would work out the same result that the gain from the recapture of depr would end up as form 4797 ordinary income. I have in this type case prepared 2 separate installment sale forms to keep it simple.

[Matt Sova]

I agree

I am in agreement with Don and Old Jack on this.