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How To Report Sales of Business Property for Income Tax Purposes

Recapture of Depreciation

When property that is subject to depreciation or amortization is sold or disposed of at a gain, part or all of the gain may have to be reported as ordinary income. The part of the gain that represents depreciation or amortization that was taken as a deduction, or could have been taken as a deduction, up until the time of the sale or disposal is the amount that must be recaptured as ordinary income.

Gains or losses from these sales or dispositions are reported in Part III of Form 4797, and include different types of property referred to according to the Internal Revenue Code sections that define their tax treatment.

Section 1245 Property

This is the case with property referred to as Section 1245 property. This type of property includes tangible personal property, such as furniture and equipment, that is subject to depreciation, or intangible personal property, such as a patent or license, that is subject to amortization.

Section 1245 property also includes certain other tangible property that is an integral part of a manufacturing, production, or extraction facility, certain infrastructure, and related research and storage facilities. Other capitalized costs subject to amortization, such as pollution control facilities, childcare facilities, the removal of barriers to disabled and elderly persons, and reforestation costs are also included in section 1245 property. But section 1245 property does not include buildings and structural components.

When section 1245 property is sold or disposed of at a gain, the part of the gain that represents recaptured depreciation or amortization is treated as ordinary income. Then, any gain remaining after that is treated as section 1231 property, for purposes of determining whether the remaining part of the gain is ordinary or capital gain. If the amount of recaptured depreciation or amortization is more than the gain on the sale or disposition, the entire amount of the gain is reported as ordinary income.

What Depreciation and Amortization Must Be Recaptured

The amounts that must be recaptured as ordinary income include the following, among others:

Ordinary depreciation deductions, and the special 30% and 50% depreciation allowances, that can be taken the first year property is placed in service, Amortization of the costs of acquiring a lease, improvements you make on property you lease, pollution control facilities, and reforestation expenses, Amortization of section 197 intangibles, which include goodwill, patents, copyrights, formulas, licenses, permits, franchises, and trademarks, Section 179 deduction, for the election to recover all or part of the cost of an asset in the year it is placed in service, Tax deductions taken for the costs of removing barriers to disabled or elderly persons, and Reductions in the basis of assets for the investment tax credit.

Section 1250 Property

Depreciation may also have to be recaptured on Section 1250 property - depreciable real property, including leaseholds if they are subject to depreciation. The amount that has to be recaptured as ordinary income is the additional depreciation allowed or allowable. Additional depreciation includes accelerated depreciation and the special 30% or 50% depreciation allowance that can be taken the year the property is place in service.

If you hold the property longer than one year, additional depreciation is the amount by which the actual depreciation you deducted, or could have deducted, exceeded the amount of depreciation calculated under the straight-line method. If you hold the property for 1 year or less, all the depreciation is additional depreciation.

Depreciation deductions taken by another person are included in the carryover basis when that person transfers the property to you. So your additional depreciation on section 1250 property that would have to be recaptured as ordinary income would be the additional depreciation taken by the previous owner and by you as the current owner, if you sell or exchange the property and have a gain.

Other Sections

Other types of property subject to the recapture rules, that are included on Form 4797 are:

Section 1252 property, which is farmland held less than 10 years, on which soil, water, or land-clearing expenses were deducted, Section 1254 property, including intangible drilling and development costs, exploration costs, and costs for developing mining operations, and Section 1255 property, which is cost-sharing payment property described in section 126 of the Internal Revenue Code.

Normally, in a sale or exchange of property, either a taxable gain or a deductible loss is realized. The gain or loss is normally determined as the difference between the total of the money, the fair market value of the property and services you receive, plus any liabilities assumed by the buyer or receiver, or that are attached to the property, and your adjusted basis in the property you sell or transfer.

But there are certain cases in which property can be exchanged and no gain or loss is recognized for federal income tax purposes. One of the most common types of non-taxable exchanges are like-kind exchanges, in which property is exchanged for other property that is similar in kind and use.

But there are certain cases in which property can be exchanged and no gain or loss is recognized for federal income tax purposes. One of the most common types of non-taxable exchanges are like-kind exchanges, in which property is exchanged for other property that is similar in kind and You must report trades of like-kind property on Form 8824, Like-Kind Exchanges. If you have a recognized gain or loss on Form 8824, you should report it on either Schedule D or Form 4797, whichever applies. Schedule D would normally be used for personal or investment assets, and Form 4797 would be used for business assets.

Real Property

The exchange of personal property for real property would not be a like-kind exchange. But the exchange of different types of real property could be considered like-kind exchanges. For example, the exchange of real property with one type of building or improvement for real property with another type of building or improvement would be considered a like-kind exchange. And exchanges of urban property for rural property, or improved property for unimproved property could qualify as like-kind exchanges.

Like-kind exchanges could include the exchange of owned real estate for leased real estate under certain conditions. For example, the exchange of owned property for property under a lease of more than 30 years could be considered a like-kind exchange.

For purposes of qualifying as nontaxable exchanges, a distinction is made between real property located in the United States and real property located outside the country. An exchange of foreign and U.S. properties would not be considered a like-kind exchange. But there is an exception for condemned property. For purposes of postponing gain on a condemnation, foreign and U.S. real property could be considered like-kind property.

Personal Property

Personal property, for these purposes, is depreciable, tangible personal property for productive use in a trade or business, or for investment purposes, and does not include property used for personal purposes. Depreciable, tangible personal property can qualify as like-kind property in a nontaxable exchange, based on different General Asset Classes and different Product Classes of property.

If the property given and the property received in an exchange fall into the same General Asset Class, or the same Product Class, they are considered like-kind property and would qualify for a nontaxable exchange.

The General Asset Classes include the following types of property:

  • Office furniture, fixtures and equipment
  • Computers and peripheral equipment
  • Data handling equipment other than computers
  • Aircraft
  • Automobiles and taxis
  • Buses
  • Light general purpose trucks
  • Heavy general purpose trucks
  • Railroad cars and locomotives
  • Tractors for over-the-road use
  • Trailers and trailer-mounted containers
  • Marine vessels
  • Steam and electric generation and distribution systems
Product Classes are those defined in the North American Industry Classification System (NAICS).

Intangible Property

Intangible property can also be considered like-kind property and can qualify for a nontaxable exchange. There are no like-classes defined for intangible property, and whether they are considered like-kind will depend on the nature of the underlying asset, and the rights involved in the intangible asset. For example, an exchange of a copyright on a book for a patent on an invention may not be considered a like-kind exchange.

Foreign and U.S. Property

Exchanges of personal property used predominately outside the United States for property used predominately inside the United States do not qualify as like-kind exchanges, even though the property may be similar in nature and use. A gain or loss on an exchange would be recognized for U.S. income tax purposes.