Section 1245 Property Issues in 1031 Exchange

Many taxpayers don’t immediately recognize that the sale of Section 1245 property is subject to depreciation recapture at ordinary income tax rates. This can be a startling discover when their tax bill is calculated. Section 1245 property is subject to tax at ordinary rates to the extent of any gain on the sale and to the extent depreciation is recognized on the property since acquisition.

Section 1245 Property is generally depreciable personal property whether tangible (such as machinery, equipment, furniture and fixtures) or intangible (such as patents, copyrights, and subscription lists). However, real property can sometimes include Section 1245 Property subject to the same depreciation recapture rules. Some examples of real property which is also Section 1245 Property include –

• Cost segregated real property that includes components which are depreciated as personal property.
• Oil and gas storage tanks, grain storage bins, silos.
• Certain commercial real estate acquired between 1981 and 1986 which was depreciated using an accelerated method.

Section 1245 property that is a part of the sale of real estate, attributable to the realized gain and depreciation taken on Section 1245 property, will be taxed at ordinary income tax rates instead of the preferred capital gains tax rates (subject to previously non-recaptured section 1231 losses).

In a 1031 exchange of real estate, realized gains are deferred if qualifying replacement property is acquired and if there is no taxable “boot” received. However, if the real estate exchanged contained any Section 1245 Property, there will be a Section 1245 depreciation recapture unless the replacement real estate also includes Section 1245 Property of equal or greater value. Any “trade-down” in the Section 1245 Property will result in Section 1245 depreciation recapture taxed at ordinary income tax rates.

Taxpayers with Section 1245 property embedded in their real property should consult with their qualified legal and tax professionals on the potential recapture occurring when contemplating either a sale or exchange. If you’ve questions on the 1031 exchange of Section 1245 property, 1031 Corporation would be happy to consult with you and your tax professional. Give us a call at 888-367-1031.