If you’re a business owner or real estate investor, you’re probably aware that you can depreciate certain business assets to maximize your company’s tax savings. Generally speaking, any investor or taxpayer seeks to minimize their tax rate as much as possible, so understanding how specific assets can be deducted is a helpful tool for accessing tax savings on an annual tax return. But depreciation might expose you to an additional tax burden: one having to do with any Section 1245 property that relates to commercial real estate and business property investments.
In this article, we’ll answer the question of “What is a Section 1245 property?” as well as explore how it affects a real estate investor’s tax savings strategies. Filing taxes correctly is crucial for accurately reaping the benefits of real estate investments and staying square with the IRS. With FortuneBuilders’ helpful guide for understanding Section 1245 property, those filing their taxes can feel rest assured everything is good to go for tax season.
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What is a Section 1245 Property?
According to the Internal Revenue Service Code, the definition of a Section 1245 property is any property classified as an intangible or tangible personal property and subject to depreciation or amortization. Buildings and structural components are not included. You own a Section 1245 property if:
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The property plays an integral role in manufacturing, production, and extraction; or providing transportation, communications, electricity, gas, water, or sewage disposal for business operations.
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The property is a research facility for any of the activities listed in Item 1
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The property is a facility for any of the activities in Item 1, or it’s used for the bulk storage of fungible commodities
[Pro Tip: Fungible commodities are goods that can be exchanged for equal amounts of the same kind—like oil.]
Examples of Section 1245 Property
Now that we’ve explored the definition of Section 1245 property let’s dive a little deeper into what this property can look like. In Section 1245, “property” isn’t necessarily always referring to real estate in the traditional sense. It refers to any asset that plays a critical part in a business operation, from vehicles to specific operational equipment. To get a better idea of what type of property can be considered Section 1245 property, let’s explore a few examples of assets that could be considered Section 1245 properties:
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Business vehicle
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Machines that are used to manufacture products
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Blast furnaces
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Storage bins for grain (another fungible good)
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Copyright or Trademarks
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Patents
Examples of Non-Section 1245 Property
While we’ve looked at a few examples of Section 1245 property outside of the real estate scope, it’s important to differentiate these unique assets from other property items that might cause confusion. Let’s answer the question of “What’s NOT considered a Section 1245 property?” with a few examples.
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Structural components in an office, warehouse, or factory—like flooring, light fixtures, roofing, HVAC systems, or plumbing
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Fencing for livestock
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Land
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Wells for livestock
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Business Inventory held for sale
The items listed above are considered “real property,” not personal property. Real property is any asset that cannot be physically moved or which is attached to the land. Section 1245 properties must be considered personal property, but they also must be used exclusively for business operations.
For example, an employee refrigerator in the office would not be considered Section 1245 property. Although it provides comfort for employees and the business owner, it’s not critically involved in producing company products or services—at least not in the IRS’s opinion. On the contrary, a business vehicle serves a direct purpose for distributing products within a business’s operations. This would be an example of a Section 1245 property.
How Does a Section 1245 Property Work?
You might be wondering, why should I care about Section 1245 properties? If you’re a business owner, you’re probably looking for ways to reduce your company’s tax burden. Many business owners do this by claiming tax deductions on their company’s depreciating assets. After all, many assets naturally depreciate because of wear and tear over time, and capitalizing on the true nature of these assets is strongly suggested when filing taxes for a Section 1245 property.
You cannot understand Section 1245 property without understanding depreciation. Section 1245 and 1250 were both created by the IRS to address the loophole that permits depreciation deductions on business assets to counterbalance regular income while taxing gain from the sale of depreciated assets as capital gains. Accounting for depreciation is a good way to save money when you’re filing taxes for your business, but there’s a significant trade-off. If you have a depreciated asset that you sell for a capital gain, then the amount you depreciated will be “recaptured.” In other words, you’ll have to pay an extra tax due to the gains realized.
Long-Term Vs. Short-Term Capital Gains
With Section 1245 property, it is important to remember the differences between long-term vs. short-term capital gains. As a refresher, long-term gains are applied when you hold an asset for more than a year. Generally long-term capital gains taxes are lower than short-term. Short-term capital gains are incurred on assets owned for less than a year — and they are often taxed at an investor’s income tax rate.
Section 1245 property must be held for longer than one year for the depreciation deduction to even apply. Despite this fact, gains realized between the adjusted cost and original cost will still be treated as short-term gains and taxed accordingly. We will discuss tax treatment more in depth below.
1245 Property Gains Tax Treatment
Now that we’ve covered the importance of depreciation within Section 1245 property, how does that impact how we file taxes and determine if an asset is depreciated. It’s as unwise to assume an asset is depreciated as it is to miss that an asset has declined in value. You may have to pay additional taxes on your 1245 property if all of the following apply:
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You sell the property for a gain
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Depreciation was taken on the property
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You held the property for more than a year
If those three rules apply, then you’ll have to pay depreciation recapture. It’s important to note that all of these conditions need to be in place for an asset to classify under a depreciation recapture for a Section 1245 property.
Section 1245 Depreciation Recapture Rules
Under depreciation recapture rules, the amount of money you depreciated will be taxed at a higher ordinary income tax rate. The rest of your sale value will be taxed at a lower tax rate that applies to 1231 properties. 1231 property is real or depreciable business property held for more than one year. It’s also worth noting that all Section 1250 property can be classified as 1231 property, but we will explore that a little further within this guide. If you sell the property for a loss, then you won’t have to pay depreciation recapture at all—the property reverts to a 1231 property and, like other ordinary losses, is subject to netting and lookback.
Let’s see how this would work in real life with an example of selling Section 1245 property.
Sale of Section 1245 Property Example
Let’s say that your business purchases a Tool for $200. You take $150 of depreciation. The Tool now has an adjusted tax basis:
Now let’s assume you sell the Tool for $250.
Of that $200 gain, the amount you depreciated ($150) is taxed at a higher ordinary income tax rate, while the remaining $50 is taxed at a lower rate for 1231 properties.
Let’s slightly adjust the formula to get an idea of when depreciation recapture wouldn’t be determined. What if you sold the Tool for a lower price compared to the purchasing price of the Tool?
Now your gain would be $0. The depreciation recapture rules would not apply to your sale in the last example. One of the largest factors of a depreciation recapture is the gains realized upon the sale of the Section 1245 property.
How To Avoid Depreciation Recapture
The easiest way to avoid depreciation recapture is not to depreciate any of your properties. If you have a property that could be considered 1245 property, then don’t claim any tax deductions on depreciation when you file your taxes. So long as you don’t depreciate, those properties will technically remain 1231 properties—not 1245 properties. Yes, that means you’ll have more of a tax burden up-front. But you’ll avoid taxes down the road if you ever sold those properties.
Think carefully about your tax planning strategy before you claim depreciation on any properties that could be considered 1245 properties. Ask yourself the following questions:
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Is it better for your business to save money this year?
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Would you rather save money down the road?
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Do you plan on selling your assets at some point?
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Will assets be unsalvageable?
Another way to avoid depreciation recapture is to sell your depreciated property for a lower price. If you’re going to sell, don’t sell for capital gain. You won’t make as much money on the sale, but you’ll also have less tax burden. [Pro Tip: It’s important to keep all your business receipts—and it doesn’t hurt to have a tax professional in your contacts list, either, who can help you with these tax-important transactions.]
But here’s another thing to keep in mind: it’s rare to sell a depreciated property for a gain. Depreciated property is, after all, depreciated property. It’s older, and it probably won’t run as effectively as it did when you bought it. Chances are, you’re going to sell it for a bargain.
If you have an asset that you’re planning on refurbishing—so you can sell for a higher price—you may want to reconsider that refurbishment if it’s going to trigger depreciation recapture.
The Difference Between a 1245 Property & 1250 Property
A common source of confusion when filing taxes and calculating if a property has depreciated is the difference between Section 1245 and 1250 property. These are different from one another, but both deal with different types of property. Section 1250 property is classified as assets that consist of real property used for business purposes over 12 months that are subject to depreciation that is not considered 1245 property (see examples above). As far as accounting goes, there are two methods to calculate depreciation:
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Straight-Line Method: Dividing the difference between an asset’s costs and expected salvage value. This accounting method evenly spreads the depreciation over the life of an asset.
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Accelerated Depreciation: This method allows you to calculate a higher amount of depreciation in the early years of an asset’s life so that you can save more money up-front.
Section 1250 of the IRS Code stipulates that you must pay depreciation recapture if you calculated depreciation with the accelerated method, and:
Section 1245 properties are not subject to this rule—this rule excludes all tangible and intangible personal properties. It can, however, affect real estate investors. If you’re a real estate investor, Section 1250 may trigger depreciation recapture if:
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You sell a property for a gain
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You depreciated the property using the Accelerated Method
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The Accelerated Depreciation is greater than what you would have saved using the Straight-Line Method
Nonetheless, this is a rare occurrence. The IRS mandates that all homes built after 1986 must be depreciated using the straight-line method. Furthermore, many properties these days tend to appreciate in value—not depreciate. Still, if you’re a real estate investor and plan on buying older properties, Section 1250 is something you want to know about.
Summary
A Section 1245 property is a personal asset that’s a critical tool in a business operation. Section 1245 properties can be depreciated when you file your taxes, but if you ever sell the property for a gain, you may be required to pay depreciation recapture. Depreciation recapture makes you pay a higher tax rate for the amount of money you had depreciated from the property. You can avoid depreciation recapture by opting not to depreciate any properties that could be considered 1245 properties or by selling them at a loss or no gain.
By understanding what type of assets are classified as Section 1245 property, business owners and investors can make better decisions regarding their taxes and ensure that they are up-to-date and accurately recorded with the IRS. Especially for those looking to save money on excessive tax payments to maximize capital gain, knowing what a Section 1245 property is can be a helpful step in the right direction. With FortuneBuilders’ guide, real estate investors and business owners can make tax season simple.
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