Transactions Excluded From General Capital Gains Rates
Certain types of transactions are excluded from general capital gains rates and are taxed at their own special rates. It is important for taxpayers to be aware of these special rates before filling out their federal tax returns.
The following types of transactions are not eligible for the general reduced capital gains rates and instead are taxed at their own specific maximum rate:
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Collectibles (taxed at 28%),
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Unrecaptured Section 1250 gain (taxed at 25%), and,
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Section 1202 gain on small business stock (taxed at 28% in some cases).
Section 1202 Gain
Unless the gain qualifies to be 100% excluded, Sec. 1202 gain is equal to the gain on the sale of small business stock that is not excluded from gross income under Code Sec. 1202. This amount may be 25% or 50% of the gain depending on when the qualifying stock was issued and whether the total gain on the sale of small business stock exceeds certain specified levels. Caution: A portion of Sec. 1202 gains is a tax preference item (unless the gain is 100% excludable). See special chapter on Small Business Stock – Chapter 2.7.
Recaptured and Unrecaptured Real Estate Rental Section 1250 Gain
A frequent question we receive is about the tax treatment of recaptured depreciation from the sale of real estate rental property. Gain from selling Sec 1250 property (real estate) is subject to recapture – the excess of the actual amount of depreciation previously claimed for the property over the amount of depreciation that would have been allowable under the straight-line method, limited to the gain on the sale, is taxed as ordinary income. However, this means that as long as the property is being depreciated using a straight-line method and held over a year, there is no Sec 1250 recapture but there will be “unrecaptured Sec 1250 gain,” which is taxed at a maximum rate of 25%. The balance of the gain, if any, is taxed at the normal capital gains rate as explained above.
Rental real estate depreciation rates have been mandatorily straight line since 1987 with residential rentals being depreciated over 27.5 years and commercial property depreciated over 31.5 years or 39 years if placed in service after 5/12/1993. Thus, in nearly all cases it is impossible for real estate property sold these days to have been depreciated at other than straight-line, and therefore no amount of depreciation is recaptured as Sec 1250 gain (Code Sec. 168(b)(3)(A)). But, the amount of depreciation claimed on Sec 1250 property that is not recaptured as ordinary income under the Sec 1250 recapture rules is unrecaptured section 1250 gain and is subject to a special capital gain tax rate of 25%.
“ Example: Jack, an individual, sells non-residential real property on Aug. 15 for $200,000, realizing a gain of $50,000. This is Jack's only transaction involving a capital asset for the year. Jack held the property for more than one year. He depreciated the property using MACRS (straight-line) and claimed $25,000 of depreciation during his ownership. There is no depreciation recapture under Sec 1250 because Jack didn't claim accelerated depreciation. However, $25,000 of Jack's gain, representing depreciation deductions he had claimed, is unrecaptured Sec. 1250 gain. Lines 26a and 26g of Jack’s Form 4797 will be zeroes because straight-line depreciation was used. The Unrecaptured Section 1250 Gain Worksheet in the Schedule D instructions will need to be completed before Jack’s Schedule D Tax Worksheet can be computed. The maximum amount of tax he’ll pay on the $25,000 of unrecaptured Sec 1250 gain is $6,250 (25% x $25,000) but his tax on the unrecaptured 1250 gain could be much less depending on his other income and the tax bracket he falls into. ”
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Special Recapture Situations
Even if straight-line depreciation is used to claim the regular depreciation deduction, depreciation recapture will apply in the following situations:
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Bonus Depreciation – If bonus depreciation is claimed on qualified leasehold improvement property placed in service before 2016 or qualified improvement property placed in service after 2015, the Sec 1250 recapture rules apply. The recapture amount is equal to the difference between the bonus deduction claimed and straight-line depreciation that could have been claimed on the bonus deduction.
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Sec 179 - If a Sec 179 deduction is claimed on Sec 1250 property (e.g., qualified leasehold improvement property, qualified restaurant property and qualified retail improvement property), the Sec 179 allowance is subject to recapture under the recapture rules of Sec 1245. In this case, to the extent the gain is allocable to the expensed portion of the property, the Sec 179 amount may be recaptured in full as ordinary income.
1244 Stock
Section 1244 allows an ordinary loss (Form 4797) on the sale of stock from a domestic corporation of up to $50,000 annually ($100,000 on a joint return, even if the stock is only owned by one of the spouses), even though the loss would otherwise be treated as a capital loss. Losses in excess of the ordinary loss treatment retain the capital loss treatment. Sec 1244 stock sold at a gain is eligible for capital gain treatment. Moreover, ordinary losses are not offset by capital gains. This means that firms can still enjoy the lower tax rate associated with capital gains which may have otherwise been netted out against a capital loss. At the same time, ordinary taxable income can be netted by ordinary losses, which reduces taxable income.
Additional Requirements:
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Only individual shareholders who purchase the stock directly from the company qualify for the special tax treatment.
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Most of the corporation's revenues must come directly from operations. In other words, most income cannot be attributed to interest, dividends, and royalties.
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Shares must be held continually since the date the stock was issued and not exchanged in the market or through private transactions.
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Section 1244 does not apply to any contributions made after the initial shares are issued. However, later contributions can qualify if the investor receives shares that were authorized, but not issued.
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Section 1244 stock should be issued pursuant to a written corporate resolution.
Sec 1244 should be considered when making choice of entity decisions along with Sec 1202 stock (qualified small business stock), Section 1202 allows companies that are sold for a gain to avoid tax. Section 1244 allows companies that are sold for a loss to be treated as ordinary losses.
Taxpayers taking advantage of the Section 1244 stock rules should document the factors that allow them to qualify. This could include corporate minutes and resolutions, accounting and bank records, and even operational records.
This is for awareness only; consult Sec 1244 rules for further details.