Understanding how personal and real property is taxed as a real estate investor and taxpayer is an important part of keeping your tax rate as low as possible. Certain assets, like 1245 property relating to commercial real estate or business property, have depreciation deductions, which can provide significant tax savings on your annual income tax return. Learn what 1245 property is, how it's taxed, and how to avoid depreciation recapture on 1245 property.
What is Section 1245 property?
According to the Internal Revenue Service (IRS), Section 1245 property is defined as intangible or tangible personal property that could be or is subject to depreciation or amortization, excluding buildings (real estate) and structural components. To be classified as 1245 property, it must do one of the following:
- Play an integral part in manufacturing, production, or extraction or in furnishing transportation, communications, electricity, gas, water, or sewage disposal services for business operations.
- Be a research facility for any of the activities in item No. 1 above.
- Be a facility in any of the activities in item No. 1 above for the bulk storage of fungible commodities, which could be, for example, oil or gas storage tanks and grain storage bins. (Oil, gas, and grain are examples of fungible goods because each can be exchanged for an equal amount of the same kind. And according to the IRS, bulk storage means the storage of a commodity in a large mass before it is used.)
A few examples of 1245 include:
- A grain storage bin.
- A business vehicle.
- Machines used for the manufacturing of a product.
- Copyright or trademark.
- Equipment such as a blast furnace.
A few examples of what would not be considered 1245 property are:
- Structural components including flooring, light fixtures, roof, HVAC system, or plumbing not required for the operation of the business.
- Fencing for the confinement of livestock.
- Wells for providing water for livestock and poultry.
As these are considered real property and not business property, they are taxed under Section 1250 property.
If a specific ventilation system is needed for the operation of the business equipment, that could be included as business property and therefore qualify as 1245 property. However, if the HVAC system is simply for the comfort of the employees or business owners, it does not play an integral role in the business operations and would not qualify.
What is classified specifically as 1245 property as compared to 1250 property can be difficult to distinguish. For this reason, a cost segregation study is required for any large business or commercial property in order to take advantage of the standard depreciation method or bonus depreciation as well as to determine the long-term capital gains tax rate or short-term capital gains tax rate upon the sale of the property or asset.
What are the depreciation recapture rules for Section 1245 property?
Section 1245 property should be subject to depreciation or amortization, which can be depreciated over a five-, seven-, or 15-year period. This can help reduce the business owner's tax basis by depreciating 1245 property at an accelerated depreciation rate compared to 1250 property.
When a business or real estate investment is sold, 1245 property that was depreciated must be recaptured. The recaptured depreciation is taxed as ordinary income up to one of the following:
- The allowed or allowable depreciation or amortization on the property.
- The gain realized on the sale or disposition.
If the asset or property is being sold as a loss, 1245 depreciation recapture rules are not applicable and it is treated as an ordinary loss that can be used to offset ordinary income.
Tax treatment of Section 1245 property gains
If the asset was held for more than a year, depreciation was taken, and there was a gain on the sale of the asset, then the property will be taxed as 1245 property until the depreciation amount has been fully recaptured.
After that, the property is treated as 1231 property under IRS publication 544, and all remaining gains are taxed at the applicable capital gain tax rate.
To see how this would work in real time, here is a basic example of the tax treatment of a Section 1245 property gain.
Let's say you purchased a piece of qualifying equipment for $10,000 that is depreciated over a seven-year period. You would have a $1,428.57 annual depreciation deduction.
After five years, you decide to sell the business and equipment. You've taken $7,142.85 in depreciation over the past five years, making your adjusted cost basis $2,857.15 ($10,000 - $7,142.85). The equipment is determined to have a fair market value of $10,500 at the time of sale.
The gain would be determined by deducting the sale amount of $10,500 minus the adjusted basis of $2,857.15, which is $7,642.85. Of the total gain amount, $7,142.85 (the amount you've taken in depreciation) would be taxed as ordinary income, and the remaining $500 would be taxed as long-term capital gains.
Avoiding depreciation recapture on Section 1245 property
Ordinary income is typically taxed at a higher income tax rate than long-term gains would be. So for those who want to reduce their tax burden further, there are ways to defer depreciation recapture on 1245 and 1250 property through a 1031 exchange which is a like-kind exchange of business, real estate, or personal property with a qualifying asset. However not all assets qualify for a 1031 exchange, and there are a number of rules and laws regarding how a like-kind exchange is conducted.
If you believe you would benefit from depreciation deductions of a 1245 property or have qualifying business assets, continue to learn about cost segregation and speak with a tax professional about the process of getting a study completed and whether it would be beneficial for you. If you do use cost segregation to take advantage of depreciation and bonus depreciation, make sure you are working with an experienced professional, especially after the sale of the asset or business.