Section 1245: Definition & How It Is Taxed

KEY TAKEAWAYS

• Section 1245 governs how capital assets that have “depreciated” for tax purposes get taxed when sold.
• Capital assets subject to Section 1245 include personal property used in a trade or business. When a capital asset subject to Section 1245 gets sold, the gain or loss on the sale will be usually considered ordinary income or loss.
• The tax treatment of gains and losses from the sale of Section 1245 assets can have significant implications for taxpayers. So it is important to understand how these rules work.
• The tax treatment of gains and losses from the sale of Section 1245 assets can have significant implications for taxpayers. So it is important to understand how these rules work.

What Is Section 1245?

Section 1245 of the Internal Revenue Code (IRC) defines eligible property as capital assets or tangible property used in business to produce income. The property might be the furniture and computers in an office or machines necessary to manufacture items. The property falls under Section 1245 if it can be depreciated over a shorter period. Thus, buildings and other real estate are not part of this IRC section, because they are depreciated over multiple decades. However, fences would still fall under this section.

It doesn’t matter if the property was acquired or sold by paying cash or if the property was exchanged for other similar property. Section 1245 will help you in figuring out if the gain or loss on the disposal of the property needs to be classified as ordinary or capital gain or loss.

What is considered 1245 property?

Section 1245 property refers to personal or tangible property. This can include office equipment, vehicles, and machinery. The property must be acquired for use in a trade or business. It also has to be held for more than a year.

1245 property depreciated over time using the straight-line method. This means that an equal amount of depreciation gets taken each year over the course of the property’s useful life. When the 1245 property sells, any remaining depreciation recaptures, which is taxed at ordinary taxable income. The gain above the allowed depreciation amount is then taxed as capital gain.

The main implication of 1245 property is that it is subject to different tax rules than other types of property. Because it is depreciable property, 1245 property typically has a lower tax basis than other types of property. This can result in a higher tax bill when the property sells.

1245 property also has different implications for businesses. Businesses can deduct the depreciation of 1245 property on their annual taxes, which can lead to significant tax savings.

It’s important to note that Section 1245 recapture only applies to gain on the sale of depreciable personal property. It does not apply to real estate or other types of property.

How is Section 1245 recapture calculated?

In this section, we want to look at how the recapture of section 1245 gets calculated. This will help you understand the tax consequences of disposing of assets that have depreciated for tax purposes.

You can calculate Section 1245 as lesser of A: allowable depreciation. Also applicable is amortization on disposed assets. Or B: gain realized upon disposition.

The first step in calculating recapture is determining the amount of allowable depreciation or amortization. This is the amount of depreciation or amortization allowed to be taken as an expense during the life of the asset.

The second step is to determine the gain realized upon disposition. This is the difference between the proceeds from disposition and the basis of the asset. The basis of the asset is the cost of the asset, plus any capital improvements, minus any depreciation that’s been taken (or should have been taken but was missed).

The final step is to compare the amount of allowable depreciation or amortization to the gain realized upon disposition. The recapture amount is the lesser of these two amounts.

So, to calculate recapture, you will need to know the following:

• The amount of allowable depreciation or amortization

• The gain realized upon disposition

• The basis of the asset

Section 1245 recapture is a tax on the sale of assets depreciated for tax purposes. The recapture amount is the lesser of the allowable depreciation or the gain realized upon disposition. The basis of the asset is the cost of the asset, plus any capital improvements, minus any depreciation taken.

Example of a Sale of Section 1245 Property

XYZ Company purchases a used machine for $100,000. They use it for 3 years before they decide to sell it for $120,000. The machine has a useful life of 5 years and has been depreciated using the straight-line method. 

Once the machine is sold, the XYZ company has a recognized gain of $80,000. $60,000 of the total is the recapture amount and will be taxed as section 1245 property using the ordinary tax rate. The remaining $20,000 will be taxed using the more favorable capital gain tax rate.

If the machine was sold for only $90,000, then the recognized gain would have been only $50,000 and would be taxed using the ordinary tax rate.  

Summary

This article covered the key points of section 1245 of the tax code. Hopefully, it provided clarity on defining this section and how it gets taxed.

As a final note, it is important to remember that tax laws are constantly changing. This article is current as of the date of publication, but the law may have changed since then. Always consult a qualified tax professional to get the most up-to-date advice on taxation.

Written by Sandra Habiger, CPA

Sandra Habiger is a Chartered Professional Accountant with a Bachelor’s Degree in Business Administration from the University of Washington. Sandra’s areas of focus include advising real estate agents, brokers, and investors. She supports small businesses in growing to their first six figures and beyond. Alongside her accounting practice, Sandra is a Money and Life Coach for women in business.

Written by Sandra Habiger, CPA

Sandra Habiger is a Chartered Professional Accountant with a Bachelor’s Degree in Business Administration from the University of Washington. Sandra’s areas of focus include advising real estate agents, brokers, and investors. She supports small businesses in growing to their first six figures and beyond. Alongside her accounting practice, Sandra is a Money and Life Coach for women in business.