§ 1.1245-4. Exceptions and limitations.

A places section 1245 property in trust to pay the income from the property to B for his life, and after B's death to distribute the property to C. If the basis of the property to the fiduciary and to C is determined under the uniform basis rules prescribed in paragraph (b) of § 1.1015-1, and under paragraph (c) of § 1.1015-1 the time the fiduciary and C acquire their interests in the property is the time the donor relinquished dominion over the property, then section 1245(a)(1) does not apply to the transfer by A to the trust or to the distribution to C.

Assume the same facts as in example (1), except that the fiduciary sells the section 1245 property and reinvests the proceeds in other section 1245 property which is distributed to C upon B's death. Assume further that under paragraph (f) of § 1.1015-1 C's basis for the distributed property is the cost or other basis to the fiduciary. Section 1245(a)(1) applies to the sale but not to the distribution.

(i) Smith transfers section 1245 property, which he has held in excess of 1 year (6 months for taxable years beginning before 1977; 9 months for taxable years beginning in 1977), to his son for $60,000. Immediately before the transfer the property in the hands of Smith has an adjusted basis of $30,000, a fair market value of $90,000, and a recomputed basis of $110,000. Since the amount realized upon disposition of the property ($60,000) is lower than its recomputed basis ($110,000), the excess of the amount realized over adjusted basis, or $30,000, is treated as ordinary income under section 1245(a)(1) and not as gain from the sale or exchange of property described in section 1231. Smith has made a gift of $30,000 ($90,000 fair market value minus $60,000 amount realized) to which section 1245(a)(1) does not apply.

(ii) Immediately before the transfer, the amount of adjustments reflected in the adjusted basis of the property was $80,000. Under paragraph (c)(2) of § 1.1245-2, $50,000 of adjustments are reflected in the adjusted basis of the property immediately after the transfer, that is, $80,000 of such adjustments immediately before the transfer, minus $30,000 gain taken into account under section 1245(a)(1) upon the transfer. Thus, the recomputed basis of the property in the hands of the son is $110,000.

Smith owns section 1245 property which, upon Smith's death, is inherited by his son. Since the property is described in section 1014(b)(1), its basis in the hands of the son is determined under the provisions of section 1014(a). Therefore, section 1245(a)(1) does not apply to the transfer at Smith's death.

H purchases section 1245 property which he conveys to himself and W, his wife, as tenants by the entirety. Upon H's death in 1970 the property (including W's share) is included in his gross estate. Since the entire property is described in section 1014(b) (1) and (9), its basis in the hands of W is determined under the provisions of section 1014(a). Therefore, section 1245(a)(1) does not apply to the transfer at H's death. For determination of the recomputed basis of the property in the hands of W, see paragraph (c)(3) of § 1.1245-2.

Green's will provides for the bequest of section 1245 property to trustees to pay the income from the property to his wife for her lifetime, and upon her death to distribute the property to his son. If under paragraph (a)(2) of § 1.1014-4 the son's unadjusted basis for the property is its fair market value at the time the decedent died, section 1245(a)(1) does not apply to the distribution of the property to the son.

The trustee of a trust created by will transfers section 1245 property to a beneficiary in satisfaction of a specific bequest of $10,000. If under the principles of paragraph (a)(3) of § 1.1014-4 the trust realizes a taxable gain upon the transfer, section 1245(a)(1) applies to the transfer.

Section 1245 property, which is owned by Smith, has a fair market value of $10,000, a recomputed basis of $8,000, and an adjusted basis of $4,000. Smith transfers the property to a corporation in exchange for stock in the corporation worth $9,000 plus $1,000 in cash in a transaction qualifying under section 351. Without regard to section 1245, Smith would recognize $1,000 gain under section 351(b), and the corporation's basis for the property would be determined under section 362(a) by reference to its basis in the hands of Smith. Since the recomputed basis of the property disposed of ($8,000) is lower than the amount realized ($10,000), the excess of recomputed basis over adjusted basis ($4,000), or $4,000, would be treated as ordinary income under section 1245(a)(1) if the provisions of section 1245(b)(3) did not apply. However, section 1245(b)(3) limits the gain taken into account by Smith under section 1245(a)(1) to $1,000. If, instead, Smith transferred the property to the corporation solely in exchange for stock of the corporation worth $10,000, then, because of the application of section 1245(b)(3), Smith would not take any gain into account under section 1245(a)(1). If, however, Smith transferred the property to the corporation for stock worth $5,000 and $5,000 cash, only $4,000 of the $5,000 gain under section 351(b) would be treated as ordinary income under section 1245(a)(1).

Assume the same facts as in example (1) except that Smith contributes the property to a new partnership in which he has a one-half interest. Since, without regard to section 1245, no gain would be recognized to Smith under section 721, and by reason of the application of section 721 the partnership's basis for the property would be determined under section 723 by reference to its basis in the hands of Smith, the application of section 1245(b)(3) results in no gain being taken into account by Smith under section 1245(a)(1).

Assume the same facts as in example (2) except that the property is subject to a $9,000 mortgage. Since under section 752(b) (relating to decrease in partner's liabilities) Smith is treated as receiving a distribution in money of $4,500 (one-half of liability assumed by partnership), and since the basis of Smith's partnership interest is $4,000 (the adjusted basis of the contributed property), the $4,500 distribution results in his realizing $500 gain under section 731(a) (relating to distributions by a partnership), determined without regard to section 1245. Accordingly, the application of section 1245(b)(3) limits the gain taken into account by Smith under section 1245(a)(1) to $500.

Smith exchanges machine A for machine B in a like kind exchange as to which no gain is recognized under section 1031(a). Both machines are section 1245 property. No gain is recognized under section 1245(a)(1) because of the limitation contained in section 1245(b)(4). The result would be the same if machine A were involuntarily converted into machine B in a transaction as to which no gain is recognized under section 1033(a)(1).

Jones owns property A, which is section 1245 property, with an adjusted basis of $100,000 and a recomputed basis of $116,000. The property is destroyed by fire and Jones receives $117,000 of insurance proceeds. Thus, the amount of gain under section 1245(a)(1), determined without regard to section 1245(b)(4), would be $16,000. He uses $105,000 of the proceeds to purchase section 1245 property similar or related in service or use to property A, and $9,000 of the proceeds to purchase stock in the acquisition of control of a corporation owning property similar or related in service or use to property A. Both acquisitions qualify under section 1033(a)(3)(A). Jones properly elects under section 1033(a)(3)(A) and the regulations thereunder to limit recognition of gain to the amount by which the amount realized from the conversion exceeds the cost of the stock and other property acquired to replace the converted property. Since $3,000 of the gain is recognized (without regard to section 1245) under section 1033(a)(3) (that is, $117,000 minus $114,000), and since the stock purchased for $9,000 is not section 1245 property and was not taken into account in determining the gain under section 1033, section 1245(b)(4) limits the amount of the gain taken into account under section 1245(a)(1) to $12,000 (that is, $3,000 plus $9,000). If, instead of purchasing $9,000 in stock, Jones purchases $9,000 worth of property which is section 1245 property similar or related in use to the destroyed property, section 1245(b)(4) would limit the amount of gain taken into account under section 1245(a)(1) to $3,000.

(i) Smith owns section 1245 property A with a fair market value of $30,000, and non-section 1245 property X with a fair market value of $20,000. Properties A and X are destroyed by fire and Smith receives insurance proceeds of $40,000. He uses all the proceeds, plus additional cash of $10,000, to purchase in a single transaction properties B and Y which qualify under section 1033(a)(3)(A), and he properly elects under section 1033(a)(3)(A) and the regulations thereunder to limit recognition of gain to the excess of the amount realized from the conversion over the costs of the qualifying properties acquired. Thus no gain would be recognized (without regard to section 1245) under section 1033(a)(3)(A). Property B is section 1245 property with a fair market value of $15,000, and property Y is non-section 1245 property with a fair market value of $35,000.

(ii) The amount realized upon the disposition of A and X ($40,000) is allocated between A and X in proportion to their respective fair market values. Thus, the amount considered realized in respect of A is $24,000 (that is, 30/50 of $40,000). (The amount considered realized in respect of X is $16,000 (that is, 20/50 of $40,000).)

(iii) The $24,000 realized upon the disposition of A is deemed to consist of the fair market value of B ($15,000) and $9,000 of the fair market value of Y. (The $16,000 realized upon the disposition of X is deemed to consist of $16,000 of the fair market value of Y. Also, $10,000 of the fair market value of Y is attributable to the additional cash of $10,000.)

(iv) Assume that A has an adjusted basis of $5,000, and a recomputed basis of $40,000. Since the amount considered realized upon the disposition of A ($24,000) is lower than its recomputed basis ($40,000), the amount of gain which would be recognized under section 1245(a)(1), determined without regard to section 1245(b)(4), is $19,000, that is, the amount realized ($24,000) minus the adjusted basis ($5,000). Since no gain is recognized (without regard to section 1245) under section 1033(a)(3), and since $9,000 of the property acquired in exchange for section 1245 property A is non-section 1245 property Y, section 1245(b)(4) limits the amount of gain taken into account under section 1245(a)(1) to $9,000.

Corporation X elects under section 1071 to treat a sale of section 1245 property for $100,000 as an involuntary conversion subject to the provisions of section 1033, but does not elect to reduce the basis of depreciable property pursuant to an election under section 1071. The corporation uses $35,000 of the proceeds to purchase section 1245 property and $40,000 to purchase other property. Both properties qualify as replacement property under section 1033. Assuming that the amount of gain under section 1245(a)(1) (determined without regard to this paragraph) would be $70,000, and that $25,000 of gain would be recognized (without regard to section 1245) upon the application of section 1071, the amount of gain taken into account under section 1245(a)(1) is $65,000 ($25,000 plus $40,000).

(i) Assume the same facts as in example (1) except that the corporation elects under section 1071 to reduce its basis for property of a character subject to the allowance for depreciation under section 167 by the amount of gain which would be recognized without regard to the application of section 1245, that is, by $25,000. Assume further that under section 1071 the corporation may reduce the basis of depreciable property consisting of property A, which is section 1245 property with an adjusted basis of $30,000, and property B, which is property other than section 1245 property with an adjusted basis of $20,000. Under paragraph (a)(2) of § 1.1071-3, the $25,000 of unrecognized gain is applied to reduce the basis of property A by $15,000 (30,000/50,000 of $25,000) and the basis of property B by $10,000 (20,000/50,000 of $25,000).

(ii) The amount of gain which would be recognized (determined without regard to section 1245) under section 1071 is zero, i.e., the amount determined in example (1) ($25,000), minus the amount of the reduction in basis of depreciable property pursuant to the election ($25,000). The amount of gain taken into account under section 1245(a)(1) is $50,000, i.e., the sum of (a) the gain which would be recognized without regard to section 1245 (zero), (b) the cost of property acquired which is not section 1245 property ($40,000), plus (c) the amount by which the basis of property B is reduced ($10,000). For method of increasing basis of property B, see paragraph (b)(2) of § 1.1245-5, and for recomputed basis of property A, see paragraph (c)(5) of § 1.1245-2.

(i) A machine, which is section 1245 property owned by partnership ABC, has an adjusted basis of $9,000, a recomputed basis of $18,000, and a fair market value of $15,000. Since the fair market value of the machine is lower than its recomputed basis, the potential section 1245 income in respect of the machine is the excess of fair market value over adjusted basis, or $6,000. The partnership distributes the machine to C in a complete liquidation of his partnership interest to which section 736(a) does not apply. C, who had originally contributed the machine to the partnership, has a basis for his partnership interest of $10,000. Since section 751(b)(2)(A) provides that section 751(b)(1) does not apply to a distribution of property to the partner who contributed the property, no gain would be recognized to the partnership under section 731(b) (without regard to the application of section 1245). By reason of the application of section 731, C's basis for the property would, under section 732(b), be equal to his basis for his interest in the partnership, or $10,000.

(ii) Since section 731 applies to the distribution, and since subparagraph (1) of this paragraph provides that, for purposes of section 1245(b)(3), C's basis for the property is deemed to be determined by reference to the adjusted basis of the property to the partnership, the gain taken into account under section 1245(a)(1) by the partnership is limited by section 1245(b)(3) so as not to exceed the amount of gain which would be recognized to the partnership if section 1245 did not apply. Accordingly, the partnership does not recognize any gain under section 1245(a)(1) upon the distribution.

(iii) Immediately after the distribution, the amount of the adjustments reflected in the adjusted basis of the property is equal to $6,000 (that is, the potential section 1245 income of the partnership in respect of the property before the distribution, $6,000, minus the gain recognized by the partnership under section 751(b), zero). Accordingly, C's recomputed basis for the property is $16,000 (that is, adjusted basis, $10,000, plus adjustments reflected in the adjusted basis, $6,000).

Assume the same facts as in example (1) except that the machine had been purchased by the partnership. Assume further that upon the distribution, the partnership recognizes $4,000 gain as ordinary income under section 751(b). Under section 1245(b)(3), gain to be taken into account under section 1245(a)(1) by the partnership is limited to $4,000. Immediately after the distribution, the amount of adjustments reflected in the adjusted basis of the property is $2,000 (that is, potential section 1245 income of the partnership, $6,000, minus gain recognized to the partnership under section 751(b), $4,000). Thus, if the adjusted basis of the machine in the hands of C were $11,333 (see, for example, the computation in paragraph (d)(2) of example (6) of paragraph (g) of § 1.751-1), the recomputed basis of the machine would be $13,333 ($11,333 plus $2,000).

Assume A owns qualified timber property (as defined in section 194(c)(1)) with a basis of $30,000. In 1981, A incurs $12,000 of qualifying reforestation expenditures and elects to amortize the maximum $10,000 of such expenses under section 194. The $10,000 of deductions are taken during the 8-year period from 1981 to 1988. If A sells the property in 1990 for $60,000 a gain of $28,000 ($60,000—adjusted basis of $32,000) is recognized on the sale. Since the sale took place within 10 years of the taxable year in which the reforestation expenditures were made, $10,000 of the gain is treated as ordinary income, and the remaining $18,000 of gain would be capital gain, if it otherwise qualifies for capital gain treatment. In order to avoid ordinary income treatment of the gain attributable to the reforestation expenditures incurred in 1981, A would have to wait until 1992 to dispose of the property.