1245 Not 1231

Published on: 18:41PM Jan 07, 2019

There are two types of gain when farmers sell farm equipment. Most of the time, the gain will be what we call Section 1245 gain. This gain is taxed at ordinary income tax rates and will qualify for the new Section 199A 20% tax deduction. This gain is a result of recapturing tax depreciation that has been taken on the equipment.

If the piece of equipment is sold for more than original cost, this excess gain is called Section 1231 gain and is taxed at capital gains rates, but is not eligible for the Section 199A deduction (at least based on proposed regulations).

Here is an example:

Judy purchases a tractor for $250,000.  She depreciates the tractor down to $50,000.  She then sells the tractor for $150,000.  The gain of $100,000 is Section 1245 gain and is taxed at regular rates, but she may be able to take a further $20,000 Section 199A deduction resulting in net total gain of $80,000.  Now, let's assume she only paid $100,000 for the tractor. The Section 1245 gain is $50,000 and the Section 1231 gain is $50,000.  The Section 199A deduction will be $10,000 for net ordinary income of $40,000 and capital gain income of $50,000.

Now if the farmer sells a piece of farm equipment that was originally traded-in on another piece of farm equipment the calculation of 1245/1231 can get tricky. In many cases, the amount of 1245 gain is understated and the amount of 1231 gain is overstated. 1231 gain does not start until the equipment is sold for more than the original cost of the equipment, not the adjusted tax basis of the equipment.

Here is an example:

Judy traded a tractor worth $100,000 on a new tractor worth $200,000.  She had fully depreciated the tractor, so her adjusted tax basis in the tractor is $100,000.  She fully depreciates the new tractor and then sells it for $150,000.  Many farmers assume that they have $100,000 of Section 1245 recapture and $50,000 of Section 1231 gain since they sold it for more than the adjusted tax basis.  The correct answer is $150,000 of 1245 recapture.  There is no 1231 gain until you sell the tractor for more than $200,000.

There are many instances where extra Section 1231 gain has been picked up on "traded" equipment. Since you can no longer do a 1031 deferred gain on these transactions, much of this extra gain will disappear over the next few years.