Depreciation recapture on conversion of business asset to personal use

Recapture of deprecation for business property
converted to personal use.

Do you have to recapture the 179 depreciation and special depreciation allowance (bonus depreciation) on a simply conversion from business use to personal use? Let’s discuss the issue of recapture.

Here is an example. Bob, an airplane pilot, has an office in his home and buys a computer. He is self employed and is using the computer 100% for business in the first year and take 179 or special allowance depreciation in the first year. In year three he decides to change his focus, and gets a job with an airline as an employee and only flies for his own clients part time. Now he uses the computer 10% of the time for business. The other 90% he uses the computer to do emails with family and friends.

So we have a self employed individual who starts a company and takes full advantage of code section 179 and special depreciation allowance provisions of the tax code. The businessman is allowed to do this because the property is being used more than 50% for the business purpose vs. personal use.

What happens to all the bonus deprecation and 179 deduction when the property is converted back to personal use. Not sold, not disposed of, but simply now used for personal use.

The issue comes down to whether the property is “listed property”. If the property is listed property, then on the conversion there is a recapture of depreciation taken in prior years.

If the property is not listed property, then the mere conversion from business to personal use creates no recapture. But if after the conversion, the property now being used personally is sold, then there could be recapture of the 179 or bonus depreciation. There is a difference between how the computer is being used vs. the sale of the computer.

What is listed property?

26 US Code §280F(d)(4) defines it as:

(4) Listed property
(A) In general Except as provided in subparagraph (B), the term “listed property” means—
(i) any passenger automobile,
(ii) any other property used as a means of transportation,
(iii) any property of a type generally used for purposes of entertainment, recreation, or amusement, and
(iv) any other property of a type specified by the Secretary by regulations.

Here is an exception for companies transporting people or property:

(B) Exception for property used in business of transporting persons or property
Except to the extent provided in regulations, clause (ii) of subparagraph (A) shall not apply to any property substantially all of the use of which is in a trade or business of providing to unrelated persons services consisting of the transportation of persons or property for compensation or hire.

Not looking so good for Bob at this point is it? But hold on, see that provision under (iv) about regulations.

If you look at Regulation §1.280F-6(b), “listed property” is further defined as

(b)Listed property –

(1)In general. Except as otherwise provided in paragraph (b)(5) of this section, the term listed property means:

(i) Any passenger automobile (as defined in paragraph (c) of this section),

(ii) Any other property used as a means of transportation (as defined in paragraph (b)(2) of this section),

(iii) Any property of a type generally used for purposes of entertainment, recreation, or amusement, and

(iv) Any computer or peripheral equipment (as defined in section 168(i)(2)(B)), and

(v) Any other property specified in paragraph (b)(4) of this section.
(b)(5) there is another exception!!! Let’s take a look at (b)(5),

(5)Exception for computers. The term listed property shall not include any computer (including peripheral equipment) used exclusively at a regular business establishment. For purposes of the preceding sentence, a portion of a dwelling unit shall be treated as a regular business establishment if (and only if) the requirements of section 280A(c)(1) are met with respect to that portion.

Bob is using his computer at his regular business establishment. And he is also okay having used his home office as his regular business establishment.

So good news for Bob. His computer is not listed property and no recapture on the simple conversion. If however he sold the computer in year 3 at a gain, then yes he would have to get out his MACRS depreciation schedule and calculated the recapture. He would report the excess depreciation on his year 3 tax return as ordinary income on form 4797.

How much is the recapture when listed property is converted from business use to personal use?

IRC §280F(b)(2)(A) says it is the difference between the “excess depreciation”.

(2) Recapture
(A) Where business use percentage does not exceed 50 percent If-
(i) property is predominantly used in a qualified business use in a taxable year in which it is placed in service, and
(ii) such property is not predominantly used in a qualified business use for any subsequent taxable year,
then any excess depreciation shall be included in gross income for the taxable year referred to in clause (ii), and the depreciation deduction for the taxable year referred to in clause (ii) and any subsequent taxable years shall be determined under section 168(g) (relating to alternative depreciation system).
(B) Excess depreciation For purposes of subparagraph (A), the term “excess depreciation” means the excess (if any) of-
(i) the amount of the depreciation deductions allowable with respect to the property for taxable years before the 1st taxable year in which the property was not predominantly used in a qualified business use, over
(ii) the amount which would have been so allowable if the property had not been predominantly used in a qualified business use for the taxable year in which it was placed in service.

See you own tax preparer for your specific issue, as this is a generic discussion.

A final thought. Now that we have a better understanding of depreciation recapture, how did we capture it in the first place?

How the 20% deduction rule works

                                         How the 20% deduction rule works
Specific Service Industries                                          All other industries
(CPAs, attorneys, brokers, Drs, etc –
But not engineers nor architects)
___________________________________________
LESSER of:                                                                       | LESSER of:
A. 20% of net business income                               A. 20% of net business income

B. 20% of taxable income                                          B. 20% of taxable income

                                                     UNDER TAXABLE INCOME

          ****TAXABLE INCOME   157,500 single 315,000 Married  ****

                                                            OVER TAXABLE INCOME

Then phase out of benefit over these levels
50,000 for single and 100,000 for Married

No 20% deduction over phase out                          LESSER of these 3 numbers:

                                                                                                                                                                                                  A. 20% of net business inc.

                                                                                                B. 20% of taxable income

                                                                                                   C.  Which is Greater?

                      1.  25% of wages + 2.5 % X cost basis  of assets

2.   50% of wages

                                                                       No 20% deduction over phase out
Taxable income greater than:
Single 207,500
Married 365,000

Converting your SEP or traditional IRA to a ROTH

Considering converting your SEP or traditional IRA to a ROTH?

Here is an example of why it may not make a difference?  It all depends on your tax rate when you retire.

  For example say your taxable income  is 170,000 for 2017.

    For 2018, if everything remains the same you will be in a 24% tax bracket (2018 24% bracket is 165,001 to 315,000).

     So  you convert 100,000 to a ROTH from your SEP.  If the tax is paid out of the converted funds (24% +6% VA), now there is 70,000 starting in the ROTH.  Notice that if you converted instead 200,000 to a ROTH,  this would put you in a 32% bracket.

      So the choice is leaving the 100,000 in the SEP and growing to be taxed at a later date,

OR

paying the tax now and having 70,000 to invest tax free.  Assume the same rate of return of 6% for both options.   Assume you and spouse are 79 and will live another 12 years per the joint annuity IRS table.

70,000   in 12 year  is worth 140,854

Leaving in SEP the 100,000 is worth 201,220.  Pay the tax at 30% =  60,366. So after taxes the amount is 140,854 (201,220 – 60,366)..  If you or you beneficiary are still in a 30% (IRS and VA) bracket, then no difference.  If you or your beneficiary are in a lower bracket then leaving the money in the SEP is best. 

 

The $64 dollar questions is what will be you  tax bracket when your retire or for your beneficiaries when you die ( for 2018 the rates are  22% 77,401 – 165,000  and the 12% bracket is 19,051 – 77,400).

Why people recommend converting is they assuming that the cash to pay the immediate tax bill will come from another source of funds and the ROTH account will start out with the 100,000.

401K Plan Contribution Calculation for the Self-Employed with Employees

401K Plan Contribution Calculation for the Self-Employed with Employees

So how much can the self employed person contribute to a 401K plan with employees for elective, non elective (safe harbor), and profit sharing?

1. As an “employee” the self employed can contribute up to 18,000 for 2017 + an additional 6,000 if 50 or older. Of course there has to be “earned income” from the self employment.

2. What if the self employed person has employees? The plan is going to required a certain level of participation for the 401K plan to be a qualified plan. Often the employees are not interested in setting aside part of their paycheck for retirement. They need all of their pay check for rent and groceries.

So the company in order for the plan to qualify has to set aside some % of the employees salary. So for example 4% of compensation is used.

And in this example the regular employees’ wages is 100,000. So 4,000 would be contributed to the employees’ 401K plan on their behalf.

Well what about the self employed person. Let’s say the net profit from schedule C is $90,000 in 2017. And the self employed person is 54 years old.

Can we set aside 4% for the self employed person? Yes but there is a calculation. The 4% is applied after the 4% is taken into consideration. Yes, it is confusing.  Let’s take a look at the 401K plan contribution calculation.

 

The 401K plan contribution calculation: an example

Net Profit Schedule C                                    90,000

Less deductible portion on SE tax           (6,358)
Line 27 of the 1040                                        ——

83,642
=======

4%/104% = .038462 X 83,642 = 3,217

3. So the third question is what if the business had a great year and the self employed person would like to make an elective contribution (a profit sharing)?

Yes that can be done. So for example the owner decides to make a 8% contribution to the regular employees’s 401K plan  in addition to the 4% safe harbor (non elective) contribution.

Can the owner also participate in the profit sharing and make a contribution to his 401K plan? Yes!

8%/108% = 7.41% is the equation for the percentage. The owners profit sharing amount would be 83,642 X .0741 = 6,198.

So in total the owner can contribute 18,000 + 6,000 + 3,217 + 6,198 = 33,415.

Please keep in mind there is a top limits that can be contributed. 54,000 + 6,000 for the over the age of 50 catch up.

Make sure to see your tax advisor regarding your particular situation.

Quickbooks Adjusting Accounts Receivable: Writing Off Over Payments and Bad Debts

 

Quickbooks  in Adjusting Accounts Receivable

If your business uses receivable accounts to track customer payments chances are you have a few customers that have over payed or refuse to pay for products or services. In either case these receivables will stay on the books unless they are cleared out.  Here is how to use Quickbooks in Adjusting Accounts Receivable.

Clearing out an over payment:

We will be using an invoice to zero out over an payment in a customer’s receivable account. The over payment will be written off into an expense account. It is recommended that you create an ‘Other Expense’ account specifically for this. This way if an adjustment needs to be changed or deleted it can found easily.

If you haven’t done so already create a new ‘Other Expense’ account:

1. Begin by opening the ‘Chart of Accounts’ window. On the top menu bar click on ‘Accountant’ and select ‘Chart of Accounts’ from the drop down.
2. Right click in the window and select ‘New’ to create a new account.
3. Select ‘Other Account Types’ at the bottom of the window. In the drop down next to this option select ‘Other Expense.’
4. Click ‘Continue’ in the bottom right corner of the window.
5. Name your new account. You will use to write off the overpayments. It is recommended to use a specific name like ‘A/R Adjustments.’
6. Finally click ‘Save & Close’ at the bottom of the window to finish creating the new account.

With your expense account created, make a new invoice item. This is the item that we will use to adjust customer accounts:

1. Begin by opening the ‘Item List’ window. On the top menu bar click on ‘Customers’ and select ‘Item List’ from the drop down.
2. Right click in the window and select on ‘New’ to create a new invoice item.
3. Select ‘Other Charge’ as the item type in the ‘Type’ drop down menu.
4. Give the item a descriptive name. Something like ‘Overpayment Adjustment’ is recommended.
5. Next choose the account this item will go against in the ‘Account’ drop down. Select the account created in the previous step or the account that you would like to use.
6. Finally click ‘OK’ in the top right corner of the window to finish creating the invoice item.

Now you are ready to zero out customer over payments:

1. Before you begin write down the information for the customer account you will be adjusting and the amount you will need to debit from their receivable account.
2. Begin by opening the ‘Create Invoices’ window. On the top menu bar click ‘Customers’ and select ‘Create Invoices’ from the drop down.
3. Select the customer’s account that you will be adjusting in the top left corner of the window with the ‘Customer Job’ drop down.
4. Next under the ‘Item’ field in the invoice select the invoice item you created to make accounts receivable adjustments.
5. It is recommended that you leave a detailed description of the adjustment in the ‘Description’ or ‘Memo’ fields to avoid confusion in the future.
6. Under the ‘Amount’ field enter the adjustment amount you wrote down earlier.
7. If you need to change the date the adjustment will take effect, change the ‘Date’ field to the required date.
8. Finally click the ‘Save & Close’ button in the bottom right corner of the window to finish creating the adjustment invoice.

The customer’s Accounts Receivable should now be zeroed. It is recommended that you check the customer’s receivable account to make sure the invoice was entered correctly and had the desired effect.

Clearing out a bad debt:

If your accounting is done on a cash basis or the uncollectible invoice amounts will not significantly affect your gross sales there are two simple ways to clear out bad debts. You can either issue a discount on the bad debt in question or mark as a bad debt.

Issuing a discount for an invoice:

1. Begin by opening the ‘Customers’ window. On the top menu bar click ‘Customers’ and select ‘Customer Center’ from the drop down.
2. Find and click on the customer’s name whose receivables account needs to be adjusted.
3. Find the invoice or invoices that are outstanding and double click on one to open the ‘Create Invoices’ window.
4. Insert a new item into the invoice and select ‘Discount’ for the item type.
5. Make sure to leave a specific description to avoid confusion in the futue.
6. Enter the amount being written off in the amount field.
7. Select ‘Save & close’ to finish editing the invoice.
8. Repeat these steps for any invoices that need to be written off.

Marking the Invoice as a bad debt:

1. Begin by opening the ‘Customers’ window. On the top menu bar click ‘Customers’ and select ‘Customer Center’ from the drop down.
2. Select the customer whose receivable account needs to be adjusted.
3. Find the invoice or invoices that are outstanding and double click on one to open the ‘Create Invoices’ window.
4. When the invoice opens, on the bottom left click on the ‘More’ button and select ‘Void’.
5. A window will pop up asking you to confirm voiding the invoice. Select ‘Yes’
6. Repeat steps 4 to 6 for each invoice you need to void.

Quickbooks in adjusting accounts receivable

It is recommended that you check the customers receivable account to make sure the adjustment had the intended effect.

If your business reports on an accrual basis voiding bad debts is a bit more complicated. The invoices have already been reported as income but are no not collectible. It is recommended that you talk to your accountant to find solution.

Form 8962 and Married Filing Separately

Form 8962 when filing Married Filing Separately (MFS)

If your health insurance was obtained through the government exchange and you estimated your household income was between 100% and 400% of the federal poverty line, then you got help in paying your insurance premium from the government. The Advance Payment of the Premium Tax Credit (APPTC) went right to the insurance company and you never saw that money, but you did get the benefit.

So now at the end of the year comes the time of settling up. For example if you said your were earning $XX dollars and the government advanced the health premiums based on that situation, and then it turns out your made $XXX + for the year, the IRS want some of the money back. Of course if you made more that the 400%, then the IRS wants all of it back. Or it can work the other way, if when you signed up for the Exchange you said $XXX was going to earned and you earned less, then the IRS is going to give you a credit.

You will be getting a 1095-A from the IRS. And in column C is the APPTC. This is the money the government sent to the insurance company to help pay your premium.

This is good except what happens if you decided to file a MFS tax return.

You don’t get the Premium Credit if you file MFS,  unless you meet the following exception.

1. You can file MFS if you were a victim of domestic abuse or

2.  your spouse abandoned you.
What happens when you were planing on filing Jointly and then events happen.

So let’s take an example.

When your family applied for the credit you were intending to file Married filing Jointly, but maybe circumstances change and your spouse wants a divorce, then one of the spouses may be able to filed Head of Household (HOH) living apart or Single living apart. The spouse filing HOH or Single is eligible for the premium tax credit.

So for example, maybe one spouse moved out of the house and took the child, and now qualifies for HOH. Then the remaining spouse is in the MFS category and barred from the Premium Tax Credit.

Let’s take another example. The family is living together, but the husband is a general contractor and his wife is concerned about the tax position taken on his Schedule C Sole Proprietorship. The wife does not want to be involved with a Joint tax return because of questionable deductions.

At then end of the year the 1095-A arrives, and it has your social security number and lists the covered individuals as you and your spouse and the 2 children. And in our example your spouse took both children as dependents.

You are filing MFS and are looking at the form 8962. You know you are not entitled to any credit and will have to repay your portion of the credit.

But how much and how to fill out the form?

You have to mark under Part II line 9 the YES box.

Next go to Part IV and the SS of the OTHER taxpayer – yes your spouse.

Now how much to included?
Going back to the instructions for Line 9, it talks about Your tax family and a Second tax family (your spouse and the 2 kids). In our example, we meet both conditions and so we would go to TABLE 3 of the instructions and follow the Allocation of Policy Amount.
TABLE 3 has 3 options

A. Divorced or legally separated.

B. Married at the end of the year and filing MFS

C. No Advanced payment was paid for the policy.

So our taxpayer is B.

Now we have to go to Allocation Situation 2.

If you find the Allocation Situation 2 it says 50% is to be reported on Part IV.
Then if you look at page 5 of the instructions, it tells you have to report 50% of the Advanced Premium Credit which confirms what the Allocation Situation 2 says also.

Then go part IV and put down 50%.

This is counter to what you might conclude that the husband filing MFS would report 25% and the wife with the 2 children would report 75%.

So for our example if the Advance Payment of Premium Credit reported on 1095-A- line 32 column C was 10,000, our MFS taxpayer would have to report 5,000 on line 46 of  the general contractor’s 1040.

Expensed vs. Capitalized

Repair vs. Capitalized

The question is what items can be expensed vs. capitalized?

The provisions are as follows.

1. De Minimis safe harbor. $2,500 per invoice or item (as substantiated by the invoice). If you have an audit done, then $5,000.

If the taxpayer arranges with the contractor to take the cost of a $10,000 new bathroom and have the contractor break it up into 4 invoices, does that qualify?

The IRS thought about that one.

26 CFR 1.263(a)-1(f)(6)Anti-abuse rule. If a taxpayer acts to manipulate transactions with the intent to achieve a tax benefit or to avoid the application of the limitations provided under paragraphs (f)(1)(i)(B)(1), (f)(1)(i)(D), (f)(1)(ii)(B)(1), and (f)(1)(ii)(D) of this section, appropriate adjustments will be made to carry out the purposes of this section. For example, a taxpayer is deemed to act to manipulate transactions with an intent to avoid the purposes and requirements of this section if –

(i) The taxpayer applies the de minimis safe harbor to amounts substantiated with invoices created to componentize property that is generally acquired or produced by the taxpayer (or other taxpayers in the same or similar trade or business) as a single unit of tangible property; and

(ii) This property, if treated as a single unit, would exceed any of the limitations provided under paragraphs (f)(1)(i)(B)(1), (f)(1)(i)(D), (f)(1)(ii)(B)(1), and (f)(1)(ii)(D) of this section, as applicable.

The Regulation at 26 CFR 1.263(a)-1(f)(7) gives various examples.

Let’s take an example. You buy a computer worth 2,600 and with that you buy a printer that costs $400, 2 items on one invoice. The printer qualifies, but not the computer.

A. A written accounting procedures that the firm is going to write off as an expense items of $5,000, but written procedures not required for the $2,500 limit.

B. The election must be made each year.

C. Even if you do not qualify for the election, that does not automatically mean you have to capitalize.

Let take a look at that example above where the computer costs $2,600. And change the facts so that the computer is sent to the local shop for work. Is the $2,600 of work a repair or an improvement.

It could be that the $2,600 was spent to replace a computer board that was defective and qualifies as a repair. So regardless of the the de minimis safe harbor rules the $2,600 would be deductible.

Before you address the various safe harbors you have the question is this item a Unit of Property “UOP”? Is the printer in our example above a unit of property? Is the printer dependent on another piece of property (for example the computer)? If the printer is dependent on the computer, then it does not qualify for the De Minimus safe harbor even though it cost under $2,500.

(e)Determining the unit of property – UOP

(1)In general. The unit of property rules in this paragraph (e) apply only for purposes of section 263(a) and §§ 1.263(a)-1, 1.263(a)-2, 1.263(a)-3, and 1.162-3. Unless otherwise specified, the unit of property determination is based upon the functional interdependence standard provided in paragraph (e)(3)(i) of this section.

(3)Property other than building –

(i)In general. Except as otherwise provided in paragraphs (e)(3), (e)(4), (e)(5), and (f)(1) of this section, in the case of real or personal property other than property described in paragraph (e)(2) of this section, all the components that are functionally interdependent comprise a single unit of property. Components of property are functionally interdependent if the placing in service of one component by the taxpayer is dependent on the placing in service of the other component by the taxpayer.

Special rules. However, special rules are provided for buildings (see paragraph (e)(2) of this section), plant property (see paragraph (e)(3)(ii) of this section), network assets (see paragraph (e)(3)(iii) of this section), leased property (see paragraph (e)(2)(v) of this section for leased buildings and paragraph (e)(3)(iv) of this section for leased property other than buildings), and improvements to property (see paragraph (e)(4) of this section). Additional rules are provided if a taxpayer has assigned different MACRS classes or depreciation methods to components of property or subsequently changes the class or depreciation method of a component or other item of property (see paragraph (e)(5) of this section). Property that is aggregated or subject to a general asset account election or accounted for in a multiple asset account (that is, pooled) may not be treated as a single unit of property.

Lets take a look at Buildings:

The building is in 2 parts: the Building System and the Building Structure.

A. Building Structure
B. Structural components/Building system: plumbing, electrical, HVAC, elevators, security systems, natural gas, and other components.
So once you have defined the UOP; Was the expenditure a repair or cap expenditure.

FACTS and CIRCUMSTANCES

What is a capital expenditure?

1. Betterment – amount paid to fix a material condition or material defect, material addition or materially increase productivity.
Of course what does “material” mean.

2. Restoration – replace a major component or a substantial structural part. Then of course you have to write of the cost of the component replaced. So for example a new roof. If I capitalize a new roof, then I should write off the adjusted basis of the old roof.

So now the question is what is the cost of the old roof. You will need either a cost segregation study or a IRS accepted method to determine the adjusted basis.

3. Adaption to a new or different use.

2. Small taxpayer safe harbor for OWNED or LEASED building

So lets say the cost meets the definition of a building improvement. How does this safe harbor work?

1. Taxpayer must have gross receipts less than 10,000,000.

2. Cost of building (excluded land) is less than 1,000,000.

3. Total cost of repairs and improvements do not exceed:

The LESSER of 10,000 or 2% of the original basis of the building. So even if it is an improvement, you can expense the lessor of 2% or 10,000.

3. Safe Harbor for Routine Maintenance

Even if the item is an improvement, you do not need to capitalize if:

Recurring activity

To keep property in the ordinary operating condition

You expect to preform this activity

A. Every 10 years for a Building. A new roof would last longer than 10 years so this would not be routine maintenance.

B. For non building more than once during its tax life.

For example, if you had a copier and had the repair man come out and clean, and he had to replace a part that cost $3,000. Even though the De Minimis safe harbor, and the small tax payer do not apply, the Routine Maintenance safe harbor would.

Safe Harbor for Routine Maintenance does not apply to improvements that are Betterments.
4. Facts and Circumstances – If the improvement does not qualify under the 2,500 exclusion De Minimus, nor the Small Taxpayer exclusion nor the Routine Maintenance, then look at the Facts And Circumstances.

Repair vs. Capitalized

What is a capital expenditure?

1. Betterment – amount paid to fix a material condition or material defect, material addition or materially increase productivity.

2. Restoration – replace a major component or a substantial structural part.
3. Adaption to a new or different use.

Even if you elect one of these simplfying provision it is possible that the safe harbor does not protect the entire cost.
4. IF YOU DON’T WANT TO GO THRU THIS ANALYSIS

You can elect to capitalize repair and maintenance as improvements.

Why you would want to do this, I am not sure. Possibly if you are not able to currently take the benefit of deducting the repairs and maintenance.

And the election has to be done each year.

5. Rehabilitation Plan.

Even if the cost is a repair, it may still end up being capitalized because it was part of an overall plan.

Say for example you buy a house and are going to rent it out. You decide to paint the home, patch the roof, clean the front walkway. Each of these item is a repair, but because it is part of a plan to Rehabilitate the house, then you have to capitalize. Does it matter that each of the items is separately invoiced? It certainly helps to make the case that the repairs were not part of an over Plan, but not if the overall Plan was decided before the start of the first repairs and the taxpayer is being billed as the work is completed.

How this is a better place than before the new IRS regs is hard to accept. This is a general discussion.

See you tax preparer for your particular situation  about whether a payment is a repair vs. capitalized item.

Recapture of Section 1231 ordinary losses

Recapture of Section 1231  ordinary losses

A client calls and says he is selling his rental property after owning the property for a number of years. He wants to know if he will get long term capital gains treatment. The normal answer would be “yes”.

The problem is that he sold a 2nd rental property 4 years ago at a loss. This loss was treated as a ordinary loss.

Let’s look at an example,

Say the loss on the second rental property was 60,000.

Now the long term capital gain on the current home he is selling is 100,000. The IRS says the 1st 60,000 is going to be taxed as ordinary income to “recapture” the benefit of the earlier ordinary loss, and then the remaining 40,000 is eligible for the lower long term capital gain rates.

Why is there this rule. Because the Congress did not want taxpayers selling their “loss” properties in one year and taking an ordinary loss and postponing the sale of gain property til a later year to take advantage of the long term capital gain rates.

SEE IRS publication 544 https://www.irs.gov/pub/irs-pdf/p544.pdf

Your nonrecaptured section 1231 losses are
your net section 1231 losses for the previous 5
years that have not been applied against a net
section 1231 gain. Therefore, if in any of your
five preceding tax years you had section 1231
losses, a net gain for the current year from the
sale of section 1231 assets is ordinary gain to
the extent of your prior losses. These losses are
applied against your net section 1231 gain beginning
with the earliest loss in the 5-year period.

This is not the only recapture possible. The rental property is consider IRC 1250 property and the depreciation expense taken over the years was an offset to ordinary income. Gain on the disposition of section 1250 property is treated as ordinary income to the extent of “additional depreciation” allowed or allowable on the property.

Additional depreciation is the amount over and above the amount that would have been taken using straight line depreciation. Now there are exceptions to having to recapture this additional depreciation.

Most likely the rental property in our example was place in service as a rental after July 31, 1986. If the property was placed in service after July 31, 1986, then no depreciation recapture. Why? Because after July 31, 1986, the straight line method was the norm.

Keep in mind you can have recapture of depreciation on personal property (IRC 1245) sold at a gain.

Getting back to the recapture of the 1231 loss taken 4 years ago in our example, it is hard to know how the taxpayer or the IRS would remember to offset the current year long term capital gain. Thanks to computer software that keeps a record of 1231 losses.

Make sure you see your tax preparer for your particular situation.