As the real estate market begins to rebound from the recent period of declining values, taxpayers in certain areas of the country are recognizing significant taxable gains on the sale of appreciated real estate. Taxpayers in this situation need to be informed of the tax planning opportunities available to prevent these gains from being converted from capital gains to ordinary income due to the recapture rules provided by Section 1231 of the Internal Revenue Code (IRC).
IRC Section 1231 property is real or depreciable property used in a trade or business or for the production of rental income and held for more than one year. A net taxable loss from the sale of IRC Section 1231 property is treated as an ordinary tax loss available to offset ordinary income such as wages, interest income and net rental income. Generally, a net taxable gain from the sale of IRC Section 1231 property is taxed as a capital gain (15% federal tax rate in 2012); however, IRC Section 1231(c) requires the net IRC Section 1231 gain for any taxable year to be converted to ordinary income (35% federal tax rate in 2012) to the extent that the taxpayer had net IRC Section 1231 losses for the five preceding taxable years. For example, assume a taxpayer generated a net IRC Section 1231 loss in 2008 of $1,000,000 related to the sale of real property and a net IRC Section 1231 gain in 2012 of $1,100,000. In this example, the 2012 net IRC Section 1231 gain results in ordinary income of $1,000,000 to recapture the 2008 net IRC Section 1231 ordinary loss claimed and $100,000 of capital gain income. If the taxpayer is unaware of this recapture rule and assumes the entire gain is eligible for capital gain treatment, it will come as an unwanted surprise that, based on current federal tax rates, the sale could result in additional federal tax of $200,000 ($1,000,000 x 35% ordinary income tax rate versus $1,000,000 x 15% capital gain tax rate).
Fortunately, there are several planning strategies to minimize or eliminate the impact of the IRC Section 1231 recapture rules. The most obvious of which is to defer the timing of the sale of appreciated property to be outside of the five-year recapture window. For example, if a taxpayer is considering selling appreciated property in the last quarter of the fifth year of an IRC Section 1231 recapture period, the taxpayer may want to consider delaying the sale until the following tax year to avoid the ordinary income recapture.
For those taxpayers that do not have the luxury of delaying the sale of property, consideration should be given to selling the property on an installment basis. Under the installment method, the seller recognizes taxable gain related to the sale as principal payments are collected on the installment note. Accordingly, to the extent the installment note is repaid after the five-year recapture period, the taxable gain recognized will not be recaptured as ordinary income.
An additional IRC Section 1231 ordinary income recapture planning opportunity exists for those real estate owners who hold property through a partnership or an limited liability company (LLC). For tax purposes, partnership and LLC ownership interests are generally considered capital assets and not IRC Section 1231 property. Therefore, taxable gains related to the sale of partnership and/or LLC interests are not subject to the IRC Section 1231 recapture rules. As a result, if transactions can be structured as a sale of ownership interests and not as a sale of property, the IRC Section 1231 recapture rules will not apply.
As real estate owners evaluate the tax implications associated with selling appreciated property over the next several years, the IRC Section 1231 recapture rules should be carefully considered to prevent the recharacterization of taxable gains from capital gain income to ordinary income.
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