Section 1245 and 1250 Recapture
If property subject to Section 1245 depreciation recapture is transferred, recapture income is triggered to the extent of (a) gain recognized on the exchange determined without regard to Section 1245 recapture plus (b) the FMV of like-kind property received that is non-Section 1245 property and that is not taken into account under item (a) [IRC Sec. 1245(b)(4)]
When Section 1250 property is transferred, Section 1250 recapture is recognized to the extent of (a) gain recognized on the exchange or (b) the amount by which potential Section 1250 recapture income exceeds the FMV of the Section 1250 property received in the transaction. However, any Section 1250 recapture that is not recognized carries over to the property received in the like-kind exchange [IRC Secs. 1250(d)(4)(A) and (E)].
Observation: Section 1245 recapture is generally more significant than Section 1250 recapture for two reasons. First, Section 1245 recapture occurs whenever non-Section 1245 property is received in a like-kind exchange, regardless of whether Section 1245 property is also received. Section 1250 recapture can be avoided if enough Section 1250 property (i.e., property worth at least the amount of the potential recapture) is received in the exchange. Also, for most real property placed in service after 1986, there is no Section 1250 recapture because straight-line (SL) depreciation is required and Section 1250 recapture is generally the excess of depreciation taken over the amount allowed using SL. Therefore, Section 1245 recapture continues to be an issue since it applies to all depreciation claimed, rather than only to the excess of accelerated depreciation over SL.
Caution: The Section 1245 recapture rule can cause unexpected results when the property exchanged is ACRS nonresidential real property (i.e., placed in service between 1981 and 1986) for which accelerated ACRS depreciation was used. Under IRC Sec. 1245(a)(5), before repeal by TRA ’86, such property was treated as Section 1245 recovery property (rather than Section 1250 property, which normally applies to depreciable real property). Consequently, the exchange of such property for other real estate is likely to be an exchange of Section 1245 property for Section 1250 property (i.e., non-Section 1245 property), causing recapture income.
Example : Section 1245 recapture on like-kind exchange.
Taylor bought an office building (located on land subject to a 50-year lease) for $300,000 in 1985. The building was depreciated under accelerated ACRS. When the building was fully depreciated, Taylor traded it for another building (Section 1250 property) in a transaction qualifying as a like-kind exchange. No boot was involved. The building she received was worth $500,000. Taylor realized a $500,000 ($500,000 FMV received less $0 basis given up) gain on the exchange. Because the property given up was Section 1245 property, her previous depreciation deductions are subject to recapture, as follows:
Depreciation subject to recapture
Section 1245(b) limitation:
Gain recognized before Section 1245 recapture, plus
FMV of non-Section 1245 property received (to the extent not included in
gain recognized before Section 1245 recapture)
Depreciation recapture (lesser of 1 or 2)