 Welcome to the session in which we will discuss section 1245 depreciation recapture rules. Section 1245 is a subsection of section 1231 assets. We did discuss 1231 assets in the prior session but we will do a quick review to understand where section 1245 fits within section 1231. Section 1231 assets include section 1245 and 1250, which include assets that are used in a trade in a business and held more than one year. Simply put, 1231 assets are business assets, that's one of them, and they are held more than a year. We have two types of section 1231 assets. We have 1245 assets and 1250 assets. In this session we'll focus on section 1245 assets. 1245 assets are depreciable personal property used in business. What does that mean? What are depreciable personal property? We're talking about office furniture, computers, vehicles, trucks, machinery, movable assets, assets that are not attached to the land. Those are personal asset, vehicles, anything that can move. Now we also have section 1250 asset or depreciable real property and land. Real property is building, usually building where something that's attached to the land. And the land itself is subject to section 1250 assets. Now section 1245 assets are important to learn about because they are subsection of 1231. Now 1231 are important because they provide an advantage to taxpayer. They provide certain advantage when it comes to tax treatments of gains and losses. What is that advantage? If we incur a loss for section 1231, the loss is deducted against ordinary income, which is good. It reduces our active ordinary income, W2 income. It doesn't have to be W2, it could be income from other sources, but it's ordinary income. Those on the other side are potentially treated as long term capital gain after taken into account the look back period, which what we talked about in the prior session. Now in this session, we also have to look at something called depreciationally recapture. 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Now for year one, year two, and year three. For the sake of illustration, for year one, you deducted $40,000 in depreciation, year two, $30,000, year three, $30,000. So notice in total, I depreciated the asset fully over the past three years. Now in year four, I sold this asset for let's assume $5,000, just $5,000. Now, I need to determine whether I have a gain or a loss. Well, how do I determine whether I have a gain or a loss? I take my cost, which is $100,000. I deduct my total depreciation, which is accumulated depreciation, which is also $100,000. I took the depreciation. That's going to give me an adjusted basis of zero, adjusted basis. I sold the asset for $5,000. My adjusted basis is zero. Therefore I have a gain of $5,000. Now this asset is a business asset, okay? I held this asset more than one year, therefore it's section 1231 or fine and dandy, however, can I treat this $5,000 as a capital gain? And the answer is we have to go through one more hurdle and that is to determine whether we have any depreciation recapture. What does that mean? Well, let's think about it. I paid $100,000 for this asset. That's my cost. And over the three years, year one, year two, and year three, I booked depreciation expense. And I deducted this depreciation expense against my ordinary income. Now I sold this asset and I have a gain. Well, guess what? If your gain, if this gain, this $5,000 gain is less than the depreciation, specifically less than the accumulated depreciation, then this gain is ordinary income. Why? Because think about it. You purchased the asset for $100,000. The rules allowed you to deduct $100,000 of your expenses against ordinary income. Now you sold the asset and you have a gain. You cannot also treat the gain as capital gain. Why? Gain is a result of a zero basis and this zero basis is a result of taking $100,000 of ordinary income deduction, basically depreciation. So you cannot take the expenses as a deduction, which you are allowed to. Then when you sell the asset, also treat the gain as a capital gain. So you cannot double dip. You took the expenses as an ordinary deduction. That's right. When you have a gain, that gain will have to be considered ordinary income because you fully depreciated this asset. It doesn't have to be fully as long as the gain is less than the depreciation. You have to recapture that depreciation and all what you're recapturing out of it is only $5,000. Nevertheless, you have to recapture that depreciation. So let's take a look at the rules. To capture the depreciation, I have to compute the gain on the disposition and look at the accumulated depreciation. And the amount of depreciation recapture should be the lesser of these two. Well in the prior example, accumulated depreciation was $100,000. The gain on the disposition was $15,000. So the depreciation recapture is the lesser of these two. So I have to recapture that $15,000 because it's the lesser. So this $15,000 is ordinary income. It's treated as ordinary income because it's a depreciation recapture. I already took advantage of the $100,000 of my cost. I was allowed to deduct it. So this $100,000 of my cost was already deducted as ordinary against ordinary income. It was against ordinary income deducted because it's a deduction. Therefore, when I do the gain, I have to do this computation. So another way to look at it is something, let me give you another simpler example. Let's assume we have an asset, maybe I would use different colors. This is good. Let's assume I purchase an asset for $100, that's my cost. And I have accumulated depreciation of $70. So this is the asset, 0, 100. And up to this point, up to $70, I already took, this is all accumulated depreciation of $70, this is $70 here. Now let's assume I sold this asset, I sold this asset. Let's see, I sold it for $10, sold for $10. Well, what's my adjusted basis? Well, my adjusted basis is $100 minus $70, $100 minus $70 equal to $30. Well, if I sold it for $10, $10 minus $30, I have a loss of $20. Well, the loss is ordinary, it's ordinary loss, ordinary income loss. Let's assume I sold this asset for $80. Well, if I sold it for $80 minus adjusted basis of $30, I have a gain of $50. Well, this gain is all depreciation recapture. So I did have a gain of $50,000, but the gain is lesser than the accumulated depreciation, this whole gain is ordinary income. Now let's assume I sold this asset for, sold for $150. So if I sold for $150, it's up here. So $150 minus $30 equal to $120 of gain. How do I characterize this gain? Well, here we go. Now this gain will have to be broken into two sorts of gain. One gain is the depreciation recapture. So $70 of this gain is depreciation recapture. And the remaining, it's the gain above, remember there's a depreciation, that's a gain that's above the original cost. $50 is capital gain. So simply put, anytime you sell the asset above its original cost, it's a capital gain, assuming you hold the asset for one year. Anytime you have a gain, and that gain is less than accumulated depreciation taking, then the gain is ordinary income. If it's above the accumulated depreciation, let's assume we sold it, again we sold it for $150, we worked this example. So this is how you have to look at it. Now let's keep going and we'll work another example as well. So when the gain of the disposition is less than the total amount of depreciation, I showed you the total gain will be treated as depreciation recapture, ordinary income. When the gain on the disposition of section 1245 is greater than the amount of accumulated depreciation, the total accumulated depreciation will be recaptured as ordinary income. And our example that I just worked, it was $70. The gain and access of the depreciation recapture will be treated as section 1231, which may potentially be long term capital gain, assuming you held the asset for more than a year. Let's look at this example. Adam, a C Corp, acquired the machinery for its use in business for $235, that's X3. Three years later, when the accumulated depreciation, total $21, they sold it for $250. So cost $235 minus $21. So the adjusted basis is $214. Now I sold the asset for $250. Well, what's my gain? $250 minus $214, that's going to give me a gain of $36,000. Well, here's what's going to happen. I have a gain of $36,000. Of that amount, of that amount of that $36,000, $21,000 is depreciation. $21,000 is depreciation and the difference between $21,000 and $36,000, which is $15,000, that's true capital treated as capital gain. So we compute the gain, $36,000, given that the amount $36,000 exceeds the accumulated depreciation because depreciation only $21,000. Therefore $21,000 will be ordinary income and the remaining $15,000 will be capital gain. Now having said so, I just want to make a few observations about section 1245 asset. Remember section 1235 asset are personal asset. What are we discussing here? We're looking at furniture, computers, vehicles, desks, chairs, office equipment. Generally speaking, generally speaking, when you sell these assets, you may sell them at a loss, generally speaking, or the depreciation would always be higher than the gain. Why? Think about it. Let's assume you purchase a furniture for a piece of furniture for $5,000. If you sold it three years later, three years later, this you might have to take a depreciation of maybe, let's assume, $3,000 per year. You took depreciation of $3,000 in total. The adjusted basis is $2,000. Now most likely than not, most likely than not, you cannot sell this asset at a gain. Most likely. And even if you sell it at a gain, the gain will not be more than $3,000, even if you sell it at a gain. It's not going to be more than the accumulated depreciation. So I just want you to think about this. So the total depreciation taken on section 1245 will exceed the gain depreciation on the disposition of asset. That's usually the case. Therefore the disposition would result in ordinary income in the real world most of the time. Okay? Section 1231 would generally occur when the section 1245 asset is disposed more than the original cost. It's less likely that you will sell this furniture more than $5,000, not likely at all. Okay? But again, it could happen. Who knows? Okay? But for personal asset, that's not the case. For real property, if you have building, land, that might be the case and that's why we have to treat those differently when we talk about section 1250. So the depreciation recapture applies to the total amount of depreciation allowed or allowable regardless whether the depreciation method used and the holding period of the property. Whether you depreciate it or not, you have to make that assumption. Now if the asset is held less than a year, guess what? It's ordinary income. It's no longer section 1231 because section 1245 is a subset of section 1231. So if you hold an asset for less than a year, then section 1231 is out of the window. And you guys have no clue how many times I trick my students over this. If it's less than a year, it's not section 1231. That's it. It's done. You have to treat it differently. Gains, you have to treat them differently. Now let's look at a comprehensive example. We have a sole proprietary, sold 1231 assets. They have a machinery with a cost of 100,000 accumulated depreciation of 53. Here we know that the adjusted basis for this asset equal to 47. We sold this asset at 90,000. Well, let's do this real quick. This way, we do it step by step. Now what you do is you will take 90,000 minus 47,000. And you'll have a gain, you have a gain of 43,000. Well, guess what? You have a gain of 43,000. That's fine. All the gain is ordinary income. Why? Because the gain is less than accumulated depreciation. We have a forklift. We acquired it for 40,000 and accumulated depreciation is 28,000. Well, what's the adjusted basis? Adjusted basis equal to 12,000. We sold it for nine. Well, guess what? If we sold it for nine and the adjusted basis is 12 and we held it for two years, it's a loss. It's ordinary loss. So we have a loss here. Three, we have a vehicle acquisition, 70,000 accumulated depreciation, 3570 minus 35. We have an adjusted basis of 35. We sold it at 40,000. We sold it at 40,000 minus 35. We have a gain of five. We have a gain of five, but it's less than the depreciation. Well, the whole gain is ordinary income. So what you do first compute the adjusted basis, 47 is the adjusted basis. The forklift has an adjusted basis of 12 and the vehicle has an adjusted basis of 35. The machinery has a gain of 43. The gain is less than the accumulated depreciation, less. The gain is less than the accumulated depreciation. The whole amount is ordinary gain. For the forklift, we have a loss. The loss is ordinary loss, section 1231 loss. The vehicle, we have a gain of five. Again, it's less than the accumulated depreciation. It's recaptured as ordinary gain. Section 1245 asset depreciation recapture is an important topic on the CPA exam. Don't take any chances on topics like this, whether it's CPA exam, enrolled agent exam, or if you are an accounting students. Go to the FARHAT lectures. Look at additional multiple choice through false additional exercises that's going to help you understand this topic better. Invest in yourself, invest in your career. Good luck, study hard, and of course, stay safe.