Understanding What is depreciation?
Determining gain (or loss) from the sale of an asset is, on the surface, a simple concept. Sale price minus adjusted basis. Figuring out how to treat the gain (or loss) from the sale of assets is where Sections 1231, 1245 and 1250 come in to play. Why does it matter? Mostly because it determines the tax rate and treatment; ordinary income or capital gain?
Section 1231 – Property is either section 1231 or it isn’t. This is the type of asset. Once it is determined to be a section 1231 asset, the asset can be further determined to be either section 1245 property or section 1250 property.
If Section 1231 property is sold and generates gain, next find out if the assets can be further characterized as Section 1245 or 1250. Capital gain items may be converted to ordinary income items which subjects them to a different tax rate.
Section 1245 – Depreciable and amortizable (section 197) personal property. From the examples above, the cars, furniture, and machine equipment are personal property under Section 1245.
Ordinary deductions are taken for depreciation on Section 1245 assets. Ordinary deductions offset ordinary income (higher tax rate), while capital losses only offset capital gains (lower tax rate). When a Section 1245 asset is sold and there is gain, some or all of the gain should be treated as ordinary income, since the deductions were taken against ordinary income. This prevents taxpayers from taking deductions against ordinary income for depreciation, and then, at sale, paying capital gains rate (lower than ordinary income rate) on the gain.
Section 1250 – very similar to section 1245 but it covers real property, as opposed to personal property. Real property includes land and buildings.
Section 1250 treatment is also calculated recapturing only deprecation taken in excess of straight-line methods. If no excess is taken, no ordinary income is recaptured.