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A Common Misconception About Section 1245 Property

A frequent misunderstanding about Section 1245 property is that it only relates to personal property. Read what types of real property qualify for Section 1245.

July 10, 2008
Sponsored by BNA Software

by Nancy Faussett, CPA

There is a common misconception that Section 1245 property consists only of personal property. This is simply not true. While Section 1245 property does include all types of personal property, it also includes certain types of real property. To be classified as Section 1245 property, the property must be depreciable or amortizable in nature. It can be personal or real, tangible or intangible.

The significance of being classified as Section 1245 property is that part or all of the gain on the property’s disposal will be treated as ordinary income under the rules for depreciation recapture.

Although most real property is Section 1250 property, there are certain types of real property that qualify as Section 1245 property. Section 1245 real property is:

  1. Tangible real property (except for buildings and their structural components) used as:

    • An integral part* of the following activities: manufacturing, production, extraction or furnishing transportation, communications, electrical energy, gas, water or sewage disposal services,
    • A research facility used in any of the above activities, or
    • A facility used in any of the above activities for the bulk storage** of fungible commodities (i.e., interchangeable goods).
  2. *Note: To be considered an "integral part" of an activity, the property must be used directly in the activity and be an essential part of the activity. Because the property must be used in one of the above mentioned specific activities to qualify as Section 1245 property, the same property may qualify as such to one taxpayer, but not to another. For example, a parking lot for a trucking business is Section 1245 property because it is an integral part of the business. However, a parking lot for a communications company’s employees is not Section 1245 property.

    ** Note: A Section 1245 "storage facility" differs from a non-Section 1245 building in that the latter may contain a work area in addition to its storage function and may reasonably be adapted to other uses. Qualifying Section 1245 structures cannot contain work areas except as necessary to care for the livestock, plants or their produce or to maintain the structure and equipment. For example, having a cash register inside a greenhouse for handling sales to the public would disqualify the structure as a Section 1245 single purpose structure.

  3. A single-purpose agricultural or horticultural structure.
  4. A storage facility (not including a building or its structural components) used in connection with the distribution of petroleum or any primary product of petroleum.
  5. A railroad grading or tunnel bore (Section 168(e)(4)).
  6. Qualified timber property (i.e., a lot located in the U.S. containing trees in significant quantities and which is intended for planting, cultivating, caring for and cutting of trees for sale or use in the commercial production of timber products). (Section 194(c)(1))
  7. That part of any real property (other than property described in #1 above), which is subject to amortization or expensing under Sections 169, 179, 179A, 179B, 179C, 179D, 190, 193 or 194. Such property is only considered Section 1245 real property to the extent that amortization is claimed on it, rather than the property in its entirety.

Section 1245 property, according to past revenue rulings, specifically does not include real property used as an integral part of the following activities:

  • Operation of a baseball sports stadium,
  • Retail sales of gasoline and related products,
  • Retail operation of a cafeteria,
  • Operation of a car wash,
  • Auction sales of livestock,
  • Operation of a ski resort, and
  • Operation of amusement park slides.

The IRS treats farming as a production activity and includes the following as Section 1245 real property:

  • Fencing for the confinement of livestock,
  • Drain tiles for irrigating cultivated fields or to improve drainage of a pasture,
  • Wells for providing water for livestock and poultry, and
  • Fruit trees held for the production of income.

A structure that is used for a special purpose is not considered a building and may qualify as Section 1245 real property. To qualify, the structure has to essentially be a piece of machinery or equipment, or an enclosure that is so closely joined with the machinery or equipment that it houses, it must be replaced or retired at the same time as the machinery or equipment. The structure is depreciated over the same recovery period as the machinery or equipment. Examples of special purpose structures are: blast furnace, brick kiln and silo.

To correctly depreciate Section 1245 property, fixed asset management software can be an invaluable tool. Once the software knows it is Section 1245 property and whether it is real or personal, it can appropriately limit the available depreciation methods, averaging conventions, and recovery periods accordingly.

Nancy Faussett, CPA, has over 25 years of tax accounting experience. With BNA Software since October 2001, Nancy serves as in-house expert on fixed assets, depreciation, and various areas of corporate and individual income taxation. Author of the Best Depreciation Guide for Best Software (now Sage), Nancy has also been published in Strategic Finance and the ACT Journal. Previously she was vice president of tax preparation for General Business Services and later worked as a depreciation and tax specialist for Best Software.