A machine bought for $60,000, depreciated to $18,000, sold for $52,000. The gain is $34,000, but none of it is capital gain. Recapture decides that, and recapture is where candidates lose points.
Basis is the taxpayer's unrecovered investment in an asset. Working any disposition of property starts with that number, because gain equals amount realized minus adjusted basis. A wrong basis means a wrong gain.
The starting basis depends on how the taxpayer acquired the asset:
Money spent on business assets is either capitalized (added to basis and recovered later) or deducted this year. Costs that acquire, produce, or improve an asset capitalize under §263 and the tangible property regulations. Costs that keep the asset in ordinary operating condition are repairs, and they're deducted currently.
For spending on assets the business already owns, the improvement test asks whether the cost is a betterment, an adaptation, or a restoration. Any of the three is an improvement and gets capitalized:
- Betterment: fixes a defect that existed before the taxpayer acquired the asset, or materially adds capacity or quality.
- Adaptation: puts the asset to a new or different use.
Common mistakes
- Netting recapture against a loss asset. Section 1245 is computed asset by asset. A $30,000 recapture gain on a machine is not reduced by a $30,000 §1231 loss on a separate building before recapture applies. The machine's $30,000 stays ordinary income.
- Using FMV as the gift basis. A donee (the person who receives the gift) generally takes the donor's basis. FMV comes in only as the limit on a loss, and only when FMV was below the donor's basis at the gift date.
- Treating a $42,000 machine trade as a like-kind exchange. Personal property lost §1031 treatment in 2018. That trade is a fully taxable disposition of property, with §1245 recapture.
Bottom line
- Gain equals amount realized minus adjusted basis; amount realized includes debt relief and excludes selling costs.
- Basis reduction uses depreciation allowed or allowable, whichever is greater.
- Section 1245 recaptures the lesser of depreciation taken or gain as ordinary income, asset by asset.
- MACRS realty produces no §1250 ordinary recapture; straight-line depreciation becomes unrecaptured §1250 gain taxed at a maximum 25 percent.
Exam shortcut
Read the asset type first. "Equipment," "machinery," or "vehicle" means §1245, and your first move is the lesser-of test. "Building," "warehouse," or "rental house" means §1250, and under MACRS the ordinary recapture answer is almost always $0 with a 25 percent bucket instead. "Exchanged" plus anything other than real estate is a trap after 2018: compute a fully taxable sale.
The full lesson (about 3,034 words, 20 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- 3
Browse all free EA Part 2 lessons or jump into free EA Part 2 practice questions.