Depreciation Recapture If you dispose of depreciable or amortizable property at a gain,you may have to treat all or part of the gain (even if otherwisenontaxable) as ordinary income. Files: To figure any gain that must be reported as ordinary income, youmust keep permanent records of the facts necessary to figure theamount of depreciation or amortization allowed or allowable on yourproperty. This includes the date and manner of acquisition, cost orother basis, depreciation or amortization, and all other adjustmentsthat affect basis. On property you got in a nontaxable exchange or as a gift, yourrecords must also indicate the following information. Whether the adjusted basis was figured using depreciation oramortization you claimed on other property. Whether the adjusted basis was figured using depreciation oramortization another person claimed. Corporate distributions.For information on property distributed by corporations, seeDistributions to Shareholders in Publication 542,Corporations. General asset accounts.Different rules apply to dispositions of property you depreciatedusing a general asset account. For information on these rules, seesection 1.168(i)-1(e) of the regulations. Section 1245 Property A gain on the disposition of section 1245 property is treated asordinary income to the extent of depreciation allowed or allowable onthe property. See Gain Treated as Ordinary Income, later. Any gain recognized that is more than the part that is ordinaryincome from depreciation is a section 1231 gain. See Treatment asordinary or capital under Section 1231 Gains and Losses,earlier. Section 1245 property.Section 1245 property includes any property that is or has beensubject to an allowance for depreciation or amortization and that isany of the following types of property. Personal property (either tangible or intangible). Other tangible property (except buildings and theirstructural components) used as any of the following. An integral part of manufacturing, production, or extractionor of furnishing transportation, communications, electricity, gas,water, or sewage disposal services. A research facility in any of the activities in (a)above. A facility in any of the activities in (a) for the bulkstorage of fungible commodities. That part of real property (not included in (2)) with anadjusted basis that was reduced by certain amortization deductions(including those for certified pollution control facilities,child-care facilities, removal of architectural barriers to personswith disabilities and the elderly, or reforestation expenses) or asection 179 deduction. Single purpose agricultural (livestock) or horticulturalstructures. Storage facilities (except buildings and their structuralcomponents) used in distributing petroleum or any primary product ofpetroleum. Buildings and structural components.Section 1245 property does not include buildings and structuralcomponents. Do not treat structures that are essentiallyitems of machinery or equipment as buildings and structuralcomponents. Also, do not treat as buildings structures that houseproperty used as an integral part of an activity if the structures'use is so closely related to the property's use that the structurescan be expected to be replaced when the property they initially houseis replaced. The fact that the structures are specially designed towithstand the stress and other demands of the property and the factthat the structures cannot be used economically for other purposesindicate that they are closely related to the use of the property theyhouse. Structures such as oil and gas storage tanks, grain storagebins, silos, fractionating towers, blast furnaces, basic oxygenfurnaces, coke ovens, brick kilns, and coal tipples are not treated asbuildings. Storage facility.This is a facility used mainly for the bulk storage of fungiblecommodities. Bulk storage means the storage of a commodity in a largemass before it is used. For example, if a facility is used to storeoranges that have been sorted and boxed, it is not used for bulkstorage. To be fungible, a commodity must be such that one part may beused in place of another. Stored materials that vary in composition,size, and weight are not fungible. One part cannot be used in place ofanother part and the materials cannot be estimated and replaced bysimple reference to weight, measure, and number. For example, thestorage of different grades and forms of aluminum scrap is not storageof fungible commodities. Gain Treated as Ordinary Income The amount of gain treated as ordinary income on the sale,exchange, or involuntary conversion of section 1245 property,including a sale and leaseback transaction, is the lesserof the following amounts. The depreciation and amortization allowed or allowable onthe property. The gain realized on the disposition (the amount realizedfrom the disposition minus the adjusted basis of the property). A limit on this amount for gain on like-kind exchanges andinvoluntary conversions is explained later. For any other disposition of section 1245 property, ordinary incomeis the lesser of (1) above or the amount by which its fair marketvalue is more than its adjusted basis. See Gifts andTransfers at Death, later. Use Part III of Form 4797 to figure the ordinary income part of thegain. Depreciation on other property or taken by other taxpayers.Depreciation and amortization include not only the amounts youclaimed on the section 1245 property but also the followingdepreciation and amortization amounts. Amounts you claimed on property you exchanged for, orconverted to, your section 1245 property in a like-kind exchange orinvoluntary conversion. Amounts a previous owner of the section 1245 propertyclaimed if your basis is determined with reference to that person'sadjusted basis (for example, the donor's depreciation deductions onproperty you received as a gift). Depreciation and amortization.Depreciation and amortization that must be recaptured as ordinaryincome include (but are not limited to) the following items. Ordinary depreciation deductions. Amortization deductions for all the following costs. The cost of acquiring a lease. The cost of lessee improvements. Pollution control facilities. Reforestation expenses. Section 197 intangibles. Child care facility expenses made before 1982. Franchises, trademarks, and trade names acquired beforeAugust 11, 1993. The section 179 expense deduction. Deductions for all the following costs. The cost of removing barriers to the disabled and theelderly. Tertiary injectant expenses. Depreciable clean-fuel vehicles and refueling property(minus the amount of any recaptured deduction). The amount of any basis reduction for the investment credit(minus the amount of any basis increase for credit recapture). The amount of any basis reduction for the qualified electricvehicle credit (minus the amount of any basis increase for creditrecapture). Example.You file your returns on a calendar year basis. In February 1997,you bought and placed in service for 100% use in your business alight-duty truck (5-year property) that cost $10,000. You used thehalf-year convention and your MACRS deductions for the truck were$2,000 in 1997 and $3,200 in 1998. You did not take the section 179deduction on it. You sold the truck in May 1999 for $7,000. The MACRSdeduction in 1999, the year of sale, is $960 (1/2 of $1,920). Figurethe gain treated as ordinary income as follows. 1) Amount realized $7,000 2) Cost (Feb. 1997) $10,000 3) Depreciation allowed or allowable (MACRSdeductions: $2,000 + $3,200 + $960)      6,160 4) Adjusted basis (subtract line 3from line 2)     $3,840 5) Gain realized (subtract line 4from line 1)     $3,160 6) Gain treated as ordinary income(lesser of line 3 or line 5) $3,160 Depreciation on other tangible property.You must take into account depreciation during periods when theproperty was not used as an integral part of an activity or did notconstitute a research or storage facility, as described earlier underSection 1245 property. For example, if depreciation deductions taken on certain storagefacilities amounted to $10,000, of which $6,000 is from the periodsbefore their use in a prescribed business activity, you must use theentire $10,000 in determining ordinary income from depreciation. Depreciation allowed or allowable.The greater of the depreciation allowed or allowable is generallythe amount to use in figuring the part of gain to report as ordinaryincome. If, in prior years, you have consistently taken properdeductions under one method, the amount allowed for your prior yearswill not be increased even though a greater amount would have beenallowed under another proper method. If you did not take any deductionat all for depreciation, your adjustments to basis for depreciationallowable are figured by using the straight line method. This treatment applies only when figuring what part of gain istreated as ordinary income under the rules for section 1245depreciation recapture. Multiple asset accounts.In figuring ordinary income from depreciation, you may treat anynumber of units of section 1245 property in a single depreciationaccount as one item if the total ordinary income from depreciationfigured by using this method is not less than it would be ifdepreciation on each unit were figured separately. Example.In one transaction you sold 50 machines, 25 trucks, and certainother property that is not section 1245 property. All of thedepreciation was recorded in a single depreciation account. Afterdividing the total received among the various assets sold, you figuredthat each unit of section 1245 property was sold at a gain. You mayfigure the ordinary income from depreciation as if the 50 machines and25 trucks were one item. However, if 5 of the trucks had been sold at a loss, only the 50machines and 20 of the trucks could be treated as one item indetermining the ordinary income from depreciation. Normal retirement.The normal retirement of section 1245 property in multiple assetaccounts does not require recognition of gain as ordinary income fromdepreciation if your method of accounting for asset retirements doesnot require recognition of that gain. Section 1250 Property A gain on the disposition of section 1250 property is treated asordinary income to the extent of additional depreciation allowed orallowable on the property. To determine the additional depreciation onsection 1250 property, see Additional Depreciation, later. You will not have additional depreciation if any of the followingconditions apply to you. You figured depreciation for the property using the straightline method or any other method that does not result in depreciationthat is more than the amount figured by the straight line method andyou have held the property longer than a year. You dispose of residential low-income rental property thatyou held for 16 2/3 years or longer (for low-income rentalhousing on which the special 60-month depreciation for rehabilitationexpenses was allowed, the 16 2/3 years starts when therehabilitated property is placed in service). You chose the alternate ACRS method for the types of 15-,18-, or 19-year real property covered by the section 1250rules. You dispose of residential rental property or nonresidentialreal property placed in service after 1986 (or after July 31, 1986, ifthe choice to use MACRS was made). These properties are depreciatedusing the straight line method. Section 1250 property.This includes all real property that is subject to an allowance fordepreciation and that is not and never has been section 1245 property.It includes a leasehold of land or section 1250 property that issubject to an allowance for depreciation. A fee simple interest inland is not included because it is not depreciable. If your section 1250 property becomes section 1245 property becauseyou change its use, you may never again treat it as section 1250property. Gain Treated as Ordinary Income To find what part of the gain from the disposition of section 1250property is treated as ordinary income, follow these steps. In a sale, exchange, or involuntary conversion of theproperty, figure the amount realized that is more than the adjustedbasis of the property. In any other disposition of the property,figure the amount of the fair market value that is more than theadjusted basis. Figure the additional depreciation for the periods after1975. Multiply the lesser of (1) or (2) by the applicablepercentage, discussed later. Stop here if this is residential rentalproperty or if (2) is equal to or more than (1). This is the gain thatis treated as ordinary income because of additionaldepreciation. Subtract (2) from (1). Figure the additional depreciation for periods after 1969but before 1976. Add the lesser of (4) or (5) to the result in (3). This isthe gain that is treated as ordinary income because of additionaldepreciation. A limit on the amount treated as ordinary income for gain onlike-kind exchanges and involuntary conversions is explained later. Use Part III, Form 4797, to figure the ordinary income part of thegain. Corporations.Hoteles UKCorporations, other than S corporations, have an additional amountto recognize as ordinary income on the sale or other disposition ofsection 1250 property. The additional amount treated as ordinaryincome is 20% of the excess of the amount that would have beenordinary income if the property were section 1245 property over theamount treated as ordinary income under section 1250. Report thisadditional ordinary income on line 26(f) of Form 4797, Part III. Additional Depreciation If you hold section 1250 property longer than 1 year, theadditional depreciation is the amount of the actual depreciationadjustments that is more than the depreciation figured using thestraight line method. For a list of items treated as depreciationadjustments, see Depreciation and amortization underSection 1245 Property, earlier. If you hold section 1250 property for 1 year or less, all of thedepreciation is additional depreciation. You will have additional depreciation if you use the regular ACRSmethod, the declining balance method, the sum-of-the-years-digitsmethod, the units-of-production method, or any other method of rapiddepreciation. You also have additional depreciation if you chooseamortization, other than amortization on real property that qualifiesas section 1245 property, discussed earlier. Depreciation taken by other taxpayers or on other property.Additional depreciation includes all depreciation adjustments tothe basis of section 1250 property whether allowed to you or anotherperson (as for carryover basis property). Example.Larry Johnson gives his son section 1250 property on which he took$2,000 in depreciation deductions, of which $500 is additionaldepreciation. Immediately after the gift, the son's adjusted basis inthe property is the same as his father's and reflects the $500additional depreciation. On January 1 of the next year, after takingdepreciation deductions of $1,000 on the property, of which $200 isadditional depreciation, the son sells the property. At the time ofsale, the additional depreciation is $700 ($500 allowed the fatherplus $200 allowed the son). Depreciation allowed or allowable.The greater of depreciation allowed or allowable (to any person whoheld the property if the depreciation was used in figuring itsadjusted basis in your hands) is generally the amount to use infiguring the part of the gain to be reported as ordinary income. Ifyou can show that the deduction allowed for any tax year was less thanthe amount allowable, the lesser figure will be the depreciationadjustment for figuring additional depreciation. Retired or demolished property.The adjustments reflected in adjusted basis generally do notinclude deductions for depreciation on retired or demolished parts ofsection 1250 property unless these deductions are reflected in thebasis of replacement property that is section 1250 property. Example.A wing of your building is totally destroyed by fire. Thedepreciation adjustments figured in the adjusted basis of the buildingafter the wing is destroyed do not include any deductions fordepreciation on the destroyed wing unless it is replaced and theadjustments for depreciation on it are reflected in the basis of thereplacement property. Figuring straight line depreciation.The useful life and salvage value you use to figure the amount thatwould have been the depreciation if you had used the straight linemethod are the same as those used under the depreciation method youactually used. If you did not use a useful life under the depreciationmethod actually used (such as with the units-of-production method) orif you did not take salvage value into account (such as with thedeclining balance method), the useful life or salvage value forfiguring what would have been the straight line depreciation is theuseful life and salvage value you would have used under the straightline method. Salvage value and useful life are not used for the ACRS method ofdepreciation. Figure straight line depreciation for ACRS real propertyby using its 15-, 18-, or 19-year recovery period as the property'suseful life. The straight line method is applied without any basis reduction forthe investment credit. Property held by lessee.If a lessee makes a leasehold improvement, the lease period forfiguring what would have been the straight line depreciationadjustments includes all renewal periods. This extension cannot extendthe period taken into account to a period that is longer than theremaining useful life of the improvement. The same rule applies to thecost of acquiring a lease. The term "renewal period" means any period for which the leasemay be renewed, extended, or continued under an option exercisable bythe lessee. However, the inclusion of renewal periods cannot extendthe lease by more than two-thirds of the period that was the basis onwhich the actual depreciation adjustments were allowed. Rehabilitation expenses.A part of the special 60-month depreciation adjustment allowed forrehabilitation expenses incurred before 1987 in connection withlow-income rental housing is additional depreciation. The additionaldepreciation is the special depreciation adjustments that are morethan the adjustments that would have resulted if the straight linemethod, normal useful life, and salvage value had been used. Example.On January 6, 1999, Fred Plums, a calendar year taxpayer, sold realproperty in which the entire basis was from rehabilitation expenses of$50,000 incurred in 1985. The property was placed in service onJanuary 3, 1986. Under the special depreciation provisions forrehabilitation expenses, the property was depreciated under thestraight line method using a useful life of 60 months (5 years) and nosalvage value. If Fred had used the regular straight line method, hewould have used a salvage value of $5,000 and a useful life of 15years, and would have had a depreciable basis of $45,000. Depreciationunder the straight line method would have been $3,000 each year (1/15 $45,000). On January 1, 1999, the additional depreciation forthe property was $11,000, figured as follows. Depreciation Claimed Straight LineDepreciation AdditionalDepreciation 1986 $10,000 $ 3,000 $ 7,000 1987 10,000 3,000 7,000 1988 10,000 3,000 7,000 1989 10,000 3,000 7,000 1990 10,000 3,000 7,000 1991 3,000 (3,000) 1992 3,000 (3,000) 1993 3,000 (3,000) 1994 3,000 (3,000) 1995 3,000 (3,000) 1996 3,000 (3,000) 1997 3,000 (3,000) 1998                 3,000    (3,000) Total $50,000 $39,000 $11,000 Applicable Percentage The applicable percentage used to figure the ordinary incomebecause of additional depreciation depends on whether the realproperty you disposed of is nonresidential real property, residentialrental property, or low-income housing. The percentages for thesetypes of real property are as follows. Nonresidential real property.For real propertythat is not residentialrental property, the applicable percentage for periods after 1969 is100%. For periods before 1970, the percentage is zero and no ordinaryincome will result on its disposition because of additionaldepreciation before 1970. Residential rental property.For residential rental property (80% or more of the gross income isfrom dwelling units) other than low-income housing, the applicablepercentage for periods after 1975 is 100%. The percentage for periodsbefore 1976 is zero. Therefore, no ordinary income will result from adisposition of residential rental property because of additionaldepreciation before 1976. Low-income housing.Low-income housing includesall the following types of residential rental property. Federally assisted housing projects if the mortgage isinsured under section 221(d)(3) or 236 of the National Housing Act orhousing financed or assisted by direct loan or tax abatement undersimilar provisions of state or local laws. Low-income rental housing for which a depreciation deductionfor rehabilitation expenses was allowed. Low-income rental housing held for occupancy by families orindividuals eligible to receive subsidies under section 8 of theUnited States Housing Act of 1937, as amended, or under provisions ofstate or local laws that authorize similar subsidies for low-incomefamilies. Housing financed or assisted by direct loan or insured underTitle V of the Housing Act of 1949. The applicable percentage for low-income housing is 100% minus 1%for each full month the property was held over 100 full months. If youhave held low-income housing at least 16 years and 8 months, thepercentage is zero and no ordinary income will result from itsdisposition. Foreclosure.If low-income housing is disposed of becauseof foreclosure or similarproceedings, the monthly applicable percentage reduction is figured asif you disposed of the property on the starting date of theproceedings. Example.On June 1, 1987, you acquired low-income housing property. On April3, 1998 (130 months after the property was acquired), foreclosureproceedings were started on the property and on December 2, 1999 (150months after the property was acquired), the property was disposed ofas a result of the foreclosure proceedings. The property qualifies fora reduced applicable percentage because it was held more than 100 fullmonths. The applicable percentage reduction is 30% (130 months minus100 months) rather than 50% (150 months minus 100 months) because itdoes not apply after April 3, 1998, the starting date of theforeclosure proceedings. Therefore, 70% of the additional depreciationis treated as ordinary income. Holding period.The holding period used to figure the applicable percentage forlow-income housing generally starts on the day after you acquired it.For example, if you bought low-income housing on January 1, 1983, theholding period starts on January 2, 1983. If you sold it on January 2,1999, the holding period is exactly 192 full months. The applicablepercentage for additional depreciation is 8%, or 100% minus 1 percentfor each full month the property was held over 100 full months. Constructed, reconstructed, or erected property.The holding period used to figure the applicable percentage forlow-income housing you constructed, reconstructed, or erected startson the first day of the month it is placed in service in a trade orbusiness, in an activity for the production of income, or in apersonal activity. Property acquired by gift or received in a tax-free transfer.For low-income housing you acquired by gift or in a tax-freetransfer the basis of which is figured by reference to the basis inthe hands of the transferor, the holding period for the applicablepercentage includes the holding period of the transferor. If the adjusted basis of the property in your hands just afteracquiring it is more than its adjusted basis to the transferor justbefore transferring it, the holding period of the difference isfigured as if it were a separate improvement. SeeLow-Income Housing With Two or More Elements, next. Low-Income HousingWith Two or More Elements If you dispose of low-income housing property that has two or moreseparate elements, the applicable percentage used to figure ordinaryincome because of additional depreciation may be different for eachelement. The gain to be reported as ordinary income is the sum of theordinary income figured for each element. The types of separate elements are: A separate improvement (defined later). The basic section 1250 property plus improvements notqualifying as separate improvements. The units placed in service at different times before allthe section 1250 property is finished. For example, this happens whena taxpayer builds an apartment building of 100 units and places 30units in service (available for renting) on January 4, 1998, 50 onJuly 18, 1998, and the remaining 20 on January 18, 1999. As a result,the apartment house consists of three separate elements. The 36-month test for separate improvements.A separate improvement is an improvement (qualifying under The1-year test, below) added to the capital account of the propertyif the total of the improvements during the 36-month period ending onthe last day of any tax year is more than the greatest of thefollowing amounts. One-fourth of the adjusted basis of the property at thestart of the first day of the 36-month period, or the first day of theholding period of the property, whichever is later. One-tenth of the unadjusted basis (adjusted basis plusdepreciation and amortization adjustments) of the property at thestart of the period determined in (1). $5,000. The 1-year test.An addition to the capital account for any tax year (including ashort tax year) is treated as an improvement only if the sum of alladditions for the year is more than the greater of $2,000 or 1% of theunadjusted basis of the property. The unadjusted basis is figured asof the start of that tax year or the holding period of the property,whichever is later. In applying the 36-month test, improvements in anyone of the 3 years are omitted entirely if the total improvements inthat year do not qualify under the 1-year test. Example.The unadjusted basis of a calendar year taxpayer's property was$300,000 on January 1, 1985. During that year, the taxpayer madeimprovements A, B, and C, which cost $1,000, $600, and $700,respectively. Since the sum of the improvements, $2,300, is less than1% of the unadjusted basis ($3,000), the improvements in 1985 do notsatisfy the 1-year test and are not treated as improvements for the36-month test. However, if improvement C had cost $1,500, the sum ofthe 1985 improvements would have been $3,100. It would then benecessary to apply the 36-month test to figure if the improvementsmust be treated as separate improvements. Addition to the capital account.Any addition to the capital account made after the initialacquisition or completion of the property by you or any person whoheld the property during a period included in your holding period isto be considered when figuring the total amount of separateimprovements. The addition to the capital account of depreciable real property isthe gross addition not reduced by amounts attributable toreplaced property. For example, if a roof with an adjusted basis of$20,000 is replaced by a new roof costing $50,000, the improvement isthe gross addition to the account, $50,000, and not the net additionof $30,000. The $20,000 adjusted basis of the old roof is no longerreflected in the basis of the property. The status of an addition tothe capital account is not affected by whether it is treated as aseparate property for determining depreciation deductions. Whether an expense is treated as an addition to the capital accountmay depend on the final disposition of the entire property. If theexpense item property and the basic property are sold in two separatetransactions, the entire section 1250 property is treated asconsisting of two distinct properties. Unadjusted basis.In figuring the unadjusted basis as of a certain date, include theactual cost of all previous additions to the capital account plusthose that did not qualify as separate improvements. However, the costof components retired before that date is not included in theunadjusted basis. Holding period.Use the following guidelines for figuring the applicable percentagefor property with two or more elements. The holding period of a separate element placed in servicebefore the entire section 1250 property is finished starts on thefirst day of the month that the separate element is placed inservice. The holding period for each separate improvement qualifyingas a separate element starts on the day after the improvement isacquired or, for improvements constructed, reconstructed, or erected,the first day of the month that the improvement is placed inservice. The holding period for each improvement notqualifying as a separate element takes the holding period of thebasic property. If an improvement by itself does not meet the 1-year test (greaterof $2,000 or 1% of the unadjusted basis), but it does qualify as aseparate improvement that is a separate element (when grouped withother improvements made during the tax year), determine the start ofits holding period as follows. Use the first day of a calendar monththat is the closest first day of a month to the middle of the taxyear. If there are two first days of a month that are equally close tothe middle of the year, use the earlier date. Figuring ordinary income attributable to each separateelement.Figure ordinary income attributable to each separate element asfollows. Step 1. Divide the element's additional depreciationafter 1975 by the sum of all the elements' additional depreciationafter 1975 to determine a percentage. Step 2. Amsterdam accommodationMultiply the percentage figured in Step 1 by thelesser of the additional depreciation after 1975 for the entireproperty or the gain from disposition of the entire property (thedifference between the fair market value or amount realized and theadjusted basis). Step 3. Multiply the result in Step 2 by the applicablepercentage for the element. Example.You sold at a gain of $25,000 low-income housing property subjectto the ordinary income rules of section 1250. The property consistedof four elements (W, X, Y, and Z). The additional depreciation foreach element is: W--$12,000; X--None; Y--$6,000; andZ--$6,000. The sum of the additional depreciation for all theelements (Step 1) is $24,000. The depreciation deducted on element Xwas $4,000 less than it would have been under the straight linemethod. Additional depreciation on the property as a whole is $20,000($24,000 minus $4,000). Because $20,000 is lower than the $25,000 gainon the sale, $20,000 is used in Step 2. The applicable percentages tobe used in Step 3 for the elements are: W--68%; X--85%;Y--92%; and Z--100%. From these facts, the sum of the ordinary income for each elementis figured as follows. Step 1 Step 2 Step 3 Ordinary Income W $12,000/$24,000 $10,000 68% $ 6,800 X -0-/24,000 -0- 85% -0- Y 6,000/24,000 5,000 92% 4,600 Z 6,000/24,000 5,000 100%      5,000 Sum of ordinary incomeof separate elements $16,400 Installment Sales If you report the sale of property under the installment method,any depreciation recapture under section 1245 or 1250 is taxable asordinary income in the year of sale. This applies even if no paymentsare received in that year. If the gain is more than the depreciationrecapture income, report the rest of the gain using the rules of theinstallment method. For this purpose, add the recapture income to theproperty's adjusted basis. If you dispose of more than one asset in a singletransaction, you must separately figure the gain on each asset so thatit may be properly reported. To do this, allocate the selling priceand the payments you receive in the year of sale to each asset. Reportany depreciation recapture income in the year of sale before using theinstallment method for any remaining gain. For a detailed discussion of installment sales, see Publication 537. Gifts If you make a gift of depreciable personal property orreal property, you do not have to report income on the transaction.However, if the person who receives it (donee) sells or otherwisedisposes of the property in a disposition that is subject torecapture, the donee must take into account the depreciation youdeducted in figuring the gain to be reported as ordinary income. For low-income housing, the donee must take into account thedonor's holding period to figure the applicable percentage. SeeApplicable Percentage and its discussion Holdingperiod under Section 1250 Property, earlier. Part gift and part sale or exchange.If you transfer depreciable personal property or real property forless than its fair market value in a transaction considered to bepartly a gift and partly a sale or exchange and you have a gainbecause the amount realized is more than your adjusted basis, you mustreport ordinary income (up to the amount of gain) to recapturedepreciation. If the depreciation (additional depreciation, if section1250 property) is more than the gain, the balance is carried over tothe transferee to be taken into account on any later disposition ofthe property. However, see Bargain sales to charity, later. Example.You transferred depreciable personal property to your son for$20,000. When transferred, the property had an adjusted basis to youof $10,000 and a fair market value of $40,000. You took depreciationof $30,000. You are considered to have made a gift of $20,000, thedifference between the $40,000 fair market value and the $20,000 saleprice to your son. You have a taxable gain on the transfer of $10,000($20,000 sale price minus $10,000 adjusted basis) that must bereported as ordinary income from depreciation. Because you report$10,000 of your $30,000 depreciation as ordinary income on thetransfer of the property, the remaining $20,000 depreciation iscarried over to your son for him to take into account on any laterdisposition of the property. Gift to charitable organization.If you give property to a charitable organization, you figure yourdeduction for your charitable contribution by reducing the fair marketvalue of the property by the ordinary income and short-term capitalgain that would have resulted had you sold the property at its fairmarket value at the time of the contribution. Thus, your deduction fordepreciable real or personal property given to a charitableorganization does not include the potential ordinary gain fromdepreciation. You also may have to reduce the fair market value of thecontributed property by the long-term capital gain (including anysection 1231 gain) that would have resulted had the property beensold. For more information, see Giving Property That HasIncreased in Value in Publication 526,CharitableContributions. Bargain sales to charity.If you transfer section 1245 or section 1250 property to acharitable organization for less than its fair market value and adeduction for the contribution part of the transfer is allowable, yourordinary income from depreciation is figured under different rules.First, figure the ordinary income as if you had sold the property atits fair market value. Then, allocate that amount between the sale andthe contribution parts of the transfer in the same proportion that youallocated your adjusted basis in the property to figure your gain.(See Bargain Sales as Gifts under Gain or Loss FromSales and Exchanges in chapter 1.)Report as ordinary income thelesser of the ordinary income allocated to the sale or your gain fromthe sale. Example.You sold section 1245 property in a bargain sale to a charitableorganization and are allowed a deduction for your contribution. Yourgain on the sale was $1,200, figured by allocating 20% of youradjusted basis in the property to the part sold. If you had sold theproperty at its fair market value, your ordinary income would havebeen $5,000. Your ordinary income is $1,000 ($5,000 20%) and your section 1231 gain is $200 ($1,200 -$1,000). Transfers at Death When a taxpayer dies, no gain is reported on depreciable personalproperty or real property that is transferred to his or her estate orbeneficiary. For information on the tax liability of a decedent, seePublication 559, Survivors, Executors, and Administrators. However, if the decedent disposed of the property while alive and,because of his or her method of accounting or for any other reason,the gain from the disposition is reportable by the estate orbeneficiary, it must be reported in the same way the decedent wouldhave had to report it if he or she were still alive. Ordinary income due to depreciation must be reported on a transferfrom an executor, administrator, or trustee to an heir, beneficiary,or other individual if the transfer is a sale or exchange on whichgain is realized. Example 1.Janet Smith owned depreciable property that, upon her death, wasinherited by her son. No ordinary income from depreciation isreportable on the transfer, even though the value used for estate taxpurposes is more than the adjusted basis of the property to Janet whenshe died. However, if she sold the property before her death andrealized a gain and if, because of her method of accounting, theproceeds from the sale are income in respect of a decedent reportableby her son, he must report ordinary income from depreciation. Example 2.The trustee of a trust created by a will transfers depreciableproperty to a beneficiary in satisfaction of a specific bequest of$10,000. If the property had a value of $9,000 at the date used forestate tax valuation purposes, the $1,000 increase in value to thedate of distribution is a gain realized by the trust. Ordinary incomefrom depreciation must be reported by the trust on the transfer. Like-Kind Exchangesand InvoluntaryConversions A like-kind exchange of your depreciable property or an involuntaryconversion of the property into similar or related property will notresult in your having to report ordinary income from depreciationunless money or property other than like-kind, similar, or relatedproperty is also received in the transaction. For information onlike-kind exchanges and involuntary conversions, see chapter 1. Depreciable personal property.If you have a gain from either a like-kind exchange or aninvoluntary conversion of your depreciable personal property, theamount to be reported as ordinary income from depreciation is theamount figured under the rules explained earlier (see Section1245 Property), limited to the sum of the followingamounts. The gain that must be included in income under the rules forlike-kind exchanges or involuntary conversions. The fair market value of the like-kind, similar, or relatedproperty other than depreciable personal property acquired in thetransaction. Example 1.You bought a new machine for $4,300 cash plus your old machine forwhich you were allowed a $1,360 trade-in. The old machine cost you$5,000 2 years ago. You took depreciation deductions of $3,950. Eventhough you deducted depreciation of $3,950, the $310 gain ($1,360trade-in allowance minus $1,050 adjusted basis) is not reportedbecause it is postponed under the rules for like-kind exchanges andyou received only depreciable personal property in the exchange. Example 2.You bought office machinery for $1,500 2 years ago and deducted$780 depreciation. This year a fire destroyed the machinery and youreceived $1,200 from your fire insurance, realizing a gain of $480($1,200 minus $720 adjusted basis). You choose to postpone reportinggain, but replacement machinery cost you only $1,000. Your taxablegain under the rules for involuntary conversions is limited to theremaining $200 insurance payment. Because all of your replacementproperty is depreciable personal property, your ordinary income fromdepreciation is limited to $200. Example 3.A fire destroyed office machinery you bought for $116,000. Thedepreciation deductions were $91,640, and the machinery had anadjusted basis of $24,360. You got a $117,000 insurance payment,realizing a gain of $92,640. You immediately spent $105,000 of the insurance payment forreplacement machinery and $9,000 for stock that qualifies asreplacement property, and you choose to postpone reporting the gain.Because $114,000 of the $117,000 insurance payment was used to buyreplacement property, the gain that must be included in income underthe rules for involuntary conversions is the unexpended part, or$3,000. The part of the insurance payment ($9,000) used to buy thenondepreciable property (the stock) must also be included in figuringthe gain from depreciation. The amount you must report as ordinary income on the transaction is$12,000, figured as follows. 1) Gain realized on the transaction ($92,640)limited to depreciation ($91,640) $91,640 2) Gain includible in income (unexpended amount) $3,000 Plus: FMV of property other than depreciablepersonal property (the stock)      9,000     12,000 Amount reportable as ordinary income(lesser of (1) or (2)) $12,000 If, instead of buying $9,000 in stock, you bought $9,000 worth ofdepreciable personal property that was similar or related in use tothe destroyed property, you would only report $3,000 as ordinaryincome. Depreciable real property.If you have a gain from either a like-kind exchange or involuntaryconversion of your depreciable real property, the amount to bereported as ordinary income from additional depreciation is the amountfigured under the rules explained earlier (see Section 1250Property), limited to the greater of the followingamounts. The gain that must be reported under the rules for like-kindexchanges or involuntary conversions plus the fair marketvalue of stock bought as replacement property in acquiring control ofa corporation. The gain you would have had to report as ordinary incomefrom additional depreciation had the transaction been a cash saleminus the cost (or fair market value in an exchange) of thedepreciable real property acquired. The ordinary income not reported for the year of the disposition iscarried over to the depreciable real property acquired in thelike-kind exchange or involuntary conversion as additionaldepreciation from the property disposed of. Further, to figure theapplicable percentage of additional depreciation on low-income housingto be treated as ordinary income, the holding period starts over forthe new property. Example.The state paid you $116,000 when it condemned your depreciable realproperty for public use. You bought other real property similar in useto the property condemned for $110,000 ($15,000 for depreciable realproperty and $95,000 for land). You also bought stock for $5,000 toget control of a corporation owning property similar in use to theproperty condemned. You choose to postpone reporting the gain. If thetransaction had been a sale for cash only, under the rules describedearlier, $20,000 would have been reportable as ordinary income becauseof additional depreciation. The ordinary income to be reported is $6,000, which is the greaterof the following amounts. The gain that must be reported under the rules forinvoluntary conversions, $1,000 ($116,000 - $115,000) plusthe fair market value of stock bought as qualified replacementproperty, $5,000, for a total of $6,000. The gain you would have had to report as ordinary incomefrom additional depreciation ($20,000) had this transaction been acash sale minus the cost of the depreciable real propertybought ($15,000), or $5,000. The ordinary income not reported, $14,000 ($20,000 - $6,000),is carried over to the depreciable real property you bought asadditional depreciation. Basis of property acquired.If the ordinary income that you have to report because ofadditional depreciation is limited, the total basis of the propertyyou acquired is its fair market value (its cost, if bought to replaceproperty involuntarily converted into money) minus the gain postponed. If you acquired more than one item of property, allocate the totalbasis among the properties in proportion to their fair market value(their cost, in an involuntary conversion into money). However, if youacquired both depreciable real property and other property, allocatethe total basis as follows. Subtract the ordinary income because of additionaldepreciation that you do not have to report from the fair market value(or cost) of the depreciable real property acquired. Add the fair market value (or cost) of the other propertyacquired to the result in (1). Divide the result in (1) by the result in (2). Multiply the total basis by the result in (3). This is thebasis of the depreciable real property acquired. If you acquired morethan one item of depreciable real property, allocate this basis amountamong the properties in proportion to their fair market value (orcost). Subtract the result in (4) from the total basis. This is thebasis of the other property acquired. If you acquired more than oneitem of other property, allocate this basis amount among theproperties in proportion to their fair market value (or cost). Example 1.In 1986, low-income housing property that you acquired and placedin service in 1981 was destroyed by fire, and you received a $90,000insurance payment. The property's adjusted basis was $38,400, withadditional depreciation of $14,932. On December 1, 1986, you used theinsurance payment to acquire and place in service replacementlow-income housing property. Your realized gain from the involuntary conversion was $51,600($90,000 - $38,400). You chose to postpone reporting the gainunder the involuntary conversion rules. Under the rules fordepreciation recapture on real property, the ordinary gain was$14,932, but you did not have to report any of it because of the limitfor involuntary conversions. The basis of the replacement low-income housing property was its$90,000 cost minus the $51,600 gain you postponed, or $38,400. The$14,932 ordinary gain that you did not report is treated as additionaldepreciation on the replacement property. When you dispose of theproperty, your holding period for figuring the applicable percentageof additional depreciation to report as ordinary income will havebegun December 2, 1986, the day after you acquired the property. Example 2.John Adams gets a $90,000 fire insurance payment for depreciablereal property (office building) with an adjusted basis of $30,000. Heuses the whole payment to buy property similar in use, spending$42,000 for depreciable real property and $48,000 for land. He choosesto postpone reporting the $60,000 gain realized on the involuntaryconversion. Of this gain, $10,000 is ordinary income from additionaldepreciation but is not reported because of the limit for involuntaryconversions of depreciable real property. The basis of the propertybought is $30,000 ($90,000 - $60,000), allocated as follows. The $42,000 cost of depreciable real property minus $10,000ordinary income that is not reported is $32,000. The $48,000 cost of other property (land) plus the $32,000figured in (1) is $80,000. The $32,000 figured in (1) divided by the $80,000 figured in(2) is 0.4. The basis of the depreciable real property is $12,000. Thisis the $30,000 total basis multiplied by the 0.4 figured in(3). The basis of the other property (land) is $18,000. This isthe $30,000 total basis minus the $12,000 figured in (4). hotel a GlasgowThe ordinary income that is not reported ($10,000) is carried overas additional depreciation to the depreciable real property that wasbought and may be taxed as ordinary income on a later disposition. Multiple Properties If you dispose of both depreciable property and other property inone transaction and realize a gain, you must allocate the amountrealized between the two types of property in proportion to theirrespective fair market values to figure the part of your gain to bereported as ordinary income from depreciation. Different rules mayapply to the allocation of the amount realized on the sale of abusiness that includes a group of assets. See chapter 2. In general, if a buyer and seller have adverse interests as to theallocation of the amount realized between the depreciable property andother property, any arm's-length agreement between them will establishthe allocation. In the absence of an agreement, the allocation should be made bytaking into account the appropriate facts and circumstances. Theseinclude, but are not limited to, a comparison between the depreciableproperty and all the other property being disposed of in thetransaction. The comparison should take into account all the followingfacts and circumstances. The original cost and reproduction cost of construction,erection, or production. The remaining economic useful life. The state of obsolescence. The anticipated expenditures required to maintain, renovate,or modernize the properties. ERROR MSGLike-kind exchanges and involuntary conversions.If you dispose of and acquire both depreciable personal propertyand other property (other than depreciable real property) in alike-kind exchange or involuntary conversion, the amount realized isallocated the following way. The amount that is allocated to thedepreciable personal property disposed of is treated as consisting of,first, the fair market value of the depreciable personal propertyacquired and, second (to the extent of any remaining balance), thefair market value of the other property acquired. The amount allocatedto the other property disposed of is treated as consisting of the fairmarket value of all property acquired that has not already been takeninto account. If you dispose of and acquire depreciable real property and otherproperty in a like-kind exchange or involuntary conversion, the amountrealized is allocated the following way. The amount that is allocatedto each of the three types of property (depreciable real property,depreciable personal property, or other property) disposed of istreated as consisting of, first, the fair market value of that type ofproperty acquired and, second (to the extent of any remainingbalance), any excess fair market value of the other types of propertyacquired. (If the excess fair market value is more than the remainingbalance of the amount realized and is from both of the other two typesof property, you can apply the unallocated amount in any manner youchoose.) Example.A fire destroyed your property with a total fair market value of$50,000. It consisted of machinery worth $30,000 and nondepreciableproperty worth $20,000. You received an insurance payment of $40,000and immediately used it with $10,000 of your own funds (for a total of$50,000) to buy machinery with a fair market value of $15,000 andnondepreciable property with a fair market value of $35,000. Theadjusted basis of the destroyed machinery was $5,000 and yourdepreciation on it was $35,000. You choose to postpone reporting yourgain from the involuntary conversion. You must report $9,000 asordinary income from depreciation arising from this transaction,figured as follows. The $40,000 insurance payment must be allocated between themachinery and the other property destroyed in proportion to the fairmarket value of each. The amount allocated to the machinery is30,000/50,000 of $40,000, or $24,000. The amount allocated to theother property is 20,000/50,000 of $40,000, or $16,000. Your gain onthe involuntary conversion of the machinery is $24,000 minus $5,000adjusted basis, or $19,000. The $24,000 allocated to the machinery disposed of istreated as consisting of the $15,000 fair market value of thereplacement machinery bought and $9,000 of the fair market value ofother property bought in the transaction. All $16,000 allocated to theother property disposed of is treated as consisting of the fair marketvalue of the other property that was bought. Your potential ordinary income from depreciation is $19,000,the gain on the machinery, because it is less than the $35,000depreciation. However, the amount you must report as ordinary incomeis limited to the $9,000 included in the amount you realized for themachinery that represents the fair market value of property other thanthe depreciable property you bought.