Depreciation Recapture

A partnership sells equipment for $30,000. The equipment's original cost was $50,000, and accumulated depreciation deductions of $35,000 have reduced its adjusted basis to $15,000. Of the $15,000 gain on the sale, how is it characterized for tax purposes? (Figures are illustrative only.)

1. A.Entirely tax-free, since the sale proceeds are less than the equipment's original costWrong. Gain is measured against adjusted basis, not original cost; the $30,000 sale price exceeds the $15,000 adjusted basis, producing taxable gain.
2. B.Entirely capital gain, since the equipment was a long-term partnership assetWrong. Depreciation previously deducted is recaptured as ordinary income rather than automatically receiving capital gain treatment.
3. C.Gain up to the amount of depreciation previously deducted is recaptured and taxed as ordinary income, rather than receiving capital gain treatmentCorrect. The $15,000 gain is recaptured as ordinary income to the extent of the depreciation previously taken.
4. D.Entirely ordinary income, since any depreciable equipment sold at a gain is automatically taxed as ordinary income in fullWrong. Recapture applies only up to the amount of depreciation previously deducted; here the full $15,000 gain happens to be within that amount, but the rule itself is not an automatic full-ordinary-income rule for every sale.

Why: Gain on the sale of depreciated equipment is recaptured as ordinary income to the extent of the depreciation previously deducted, rather than receiving capital gain treatment.

A partnership allocates depreciation deductions on a building disproportionately to Partner A under a special allocation in the partnership agreement, while Partner B receives a much smaller share of those deductions. When the building is later sold at a gain that triggers depreciation recapture, how is the recapture income most likely allocated between the two partners?

1. A.Equally between the two partners, since recapture is a sale-year event unrelated to how the original deductions were dividedWrong. Recapture is not divided independently of the prior deductions; it generally follows the same allocation as the depreciation that produced it.
2. B.Entirely to Partner B, since Partner A already received the benefit of the larger depreciation deductions during operationsWrong. This reverses the rule -- the partner who claimed more depreciation recognizes more of the resulting recapture, not less.
3. C.In proportion to each partner's current capital account balance at the time of sale, regardless of how the depreciation deductions were originally allocatedWrong. Capital account balance at sale is not the governing benchmark; the recapture follows the original depreciation allocation.
4. D.Consistent with how the underlying depreciation deductions were allocated, so Partner A, who claimed the larger share of deductions, recognizes the larger share of recapture incomeCorrect. Recapture income tracks the allocation of the depreciation deductions that generated it.

Why: Depreciation recapture income generally follows the same allocation as the depreciation deductions that produced it, so the partner who claimed the larger share of the deductions recognizes the larger share of the recapture.

An investor contributes a building to a partnership with a fair market value of $500,000 and an adjusted basis of $300,000 at the time of contribution, reflecting depreciation she had already claimed on the building before contributing it. Several years later, the partnership sells the building at a gain that includes both the pre-contribution built-in gain and additional depreciation the partnership claimed after the contribution. How must the recapture income attributable to the pre-contribution built-in gain be allocated among the partners?

1. A.It is allocated pro rata among all partners under the partnership's general profit-and-loss sharing ratio, the same as any other gain from the sale of partnership property.Wrong. Built-in gain existing at contribution, including its recapture character, is not allocated under the general profit-sharing ratio; it must be allocated to the contributing partner.
2. B.It must be allocated back to the contributing partner, not spread among all partners under the general profit-sharing ratio, because built-in gain or loss existing at the time property is contributed, including its character such as depreciation recapture, is specifically required to be allocated to the contributing partner.Correct. Built-in gain at contribution, including its recapture character, is mandatorily allocated back to the contributing partner.
3. C.It may be allocated to whichever partner the general partner designates at the time of sale, at the general partner's discretion.Wrong. This allocation is a mandatory statutory requirement tied to the contributing partner, not a discretionary choice made at the time of sale.
4. D.It is excluded from recapture treatment entirely, since the depreciation that created it was claimed before the property was ever contributed to the partnership.Wrong. Pre-contribution depreciation still carries recapture character into the partnership and must be accounted for when the property is sold.

Why: Built-in gain or loss existing at the time property is contributed, including its character such as depreciation recapture, is specifically required to be allocated back to the contributing partner, not spread among all partners under the general profit-sharing ratio.

A limited partner's adjusted basis in her partnership interest has been reduced over several years by her allocated share of depreciation on the partnership's equipment. The partnership now sells that equipment for an amount well above its remaining adjusted basis, and a substantial portion of the gain is depreciation recapture allocated to her. She assumes that because her outside basis is already low, the recapture allocated to her must be tax-free return of basis rather than taxable income. Is this assumption correct?

1. A.Yes, because gain allocated to a partner with a low outside basis is treated as a nontaxable return of basis rather than as recognized incomeWrong. A low outside basis does not convert the partnership's recognized gain into a tax-free return of basis for the partner.
2. B.Yes, because depreciation recapture is only taxable to partners whose outside basis remains above the amount of accumulated depreciationWrong. There is no such outside-basis threshold governing whether recapture is taxable; it is taxable regardless of her basis level.
3. C.No, but only because the sale price exceeded the equipment's original cost, not because of any general rule about recapture and outside basisWrong. The relevant reason is the general rule that recapture is taxable regardless of outside basis, not a comparison of sale price to original cost.
4. D.No, because the recapture is taxable ordinary income to her regardless of how low her outside basis has become; a low outside basis affects how much gain or loss she recognizes on disposing of her own interest, not the character of gain the partnership recognizes on selling its assetCorrect. The recapture allocated from the partnership's sale is taxable regardless of her low outside basis, which governs a separate transaction -- disposing of her own partnership interest.

Why: A low outside basis in the partnership interest does not shelter gain the partnership recognizes on selling its own asset. The recapture is taxable ordinary income to her regardless of how low her outside basis has become; her outside basis instead governs gain or loss on disposing of her own partnership interest, a separate transaction.