Avoid the §1239 Landmine

When capital gain income turns into ordinary income

Imagine a situation in which a taxpayer buys real property for $100,000 as a rental property, claims depreciation expense of $2,500, and sells it two years later to their own 100% owned corporation for $200,000 for use in their trade or business.

Under the regular tax rules for property transactions, the taxpayer would individually recognize $2,500 of unrecaptured §1250 gain, which is capital gain taxed at a maximum rate of 25%, and $100,000 of §1231 gain, normally long-term capital gain. These amounts are taxed at preferred tax rates, possibly as low as 0%, and can be offset with other capital losses.

The corporation’s basis in the property is increased to $200,000, so it gets higher depreciation deductions, possibly decreasing tax by more than the capital gains tax paid in the sale. This transaction essentially “swaps” tax-preferred capital gain income for ordinary tax deductions.

Assuming the property was sold for fair market value (FMV), this treatment would be allowed if not for §1239. Understanding this little-known Code section is essential for any tax professional working with corporations. While §1239 also applies to certain trust and estate transactions, this article will focus on the corporation issues.

§1239 Overview

§1239 recharacterizes the seller’s gain as ordinary if two conditions are met:

1. It is a direct or indirect sale or exchange of property between related parties, and

2. The property’s character is subject to §167 depreciation in the hands of the buyer.

§1239(b) provides for three categories of related parties:

1. A person and all entities which are controlled entities with respect to such person,

2. A taxpayer and any trust in which such taxpayer (or his spouse) is a beneficiary, unless such beneficiary’s interest in the trust is a remote contingent interest (within the meaning of §318(a)(3)(B)(i)), or

3. An executor of an estate and a beneficiary of such estate, except for a sale or exchange in satisfaction of a pecuniary bequest.

With respect to the first category of related parties, §7701(a)(1) defines a person as an individual, a trust, an estate, a partnership, an association, a company, or a corporation.

§1239(c)(1) defines the six types of controlled entities:

1. A corporation in which more than 50% of the value of the outstanding stock is owned (directly or indirectly) by or for such person,

2. A partnership in which more than 50% of the capital interest or profits interest is owned (directly or indirectly) by or for such person,

3. Two corporations that are members of the same §267(f) controlled group,

4. A corporation and a partnership in which the same persons own more than 50% in value of the outstanding stock of the corporation and more than 50% of the capital interest or profits interest in the partnership,

5. Two S corporations in which the same persons own more than 50% in value of the outstanding stock of each corporation, or

6. An S corporation and a C corporation in which the same persons own more than 50% of the value of each corporation's outstanding stock.

Under §1239(c)(2), the §267(c) constructive ownership rules (except for partners under §267(c)(3)) apply to determining ownership under §1239, further complicating when §1239 may apply to a transaction.

There are many potential transactions subject to §1239 recharacterization; however, below are two common situations where it may not be evident that §1239 would apply, but it does.

§351 Tax-Deferred Exchange

Under §351(a), one or more persons can contribute property in exchange for stock in a corporation and not recognize gain on the exchange if, immediately after the exchange, the person or persons own at least 80% of the combined voting power of all voting stock and at least 80% of all other classes of stock.

A person has to recognize gain in a §351 exchange to the extent they receive money or other property in the exchange (i.e., boot) under §351(b). In addition, §357(c) states that, in §351 exchange, if the total liabilities assumed by the corporation exceeds the total adjusted basis of the property transferred to the corporation, the person recognizes either capital or ordinary gain in the amount of the difference.

Rev. Rul. 60-302 held that the gain recognized under §351(b) and §357(c) is subject to §1239 recharacterization if the corporation is a controlled entity with respect to the person engaging in the §351 exchange.

Here’s an example: Aaron formed Yellow, Inc., transferring a factory building with an adjusted basis of $200,000 to the corporation and receiving in exchange all the stock plus a short-term note payable to himself. The factory is encumbered by a $210,000 liability that Yellow, Inc. assumes. The property transferred was used in his trade or business and held by him for more than one year.

At the time of the transfer, the building's FMV was $500,000, the stock's FMV was $210,000, and the note's FMV was the same as its face value of $80,000. Aaron's transfer of this asset in return for stock and a note constituted the only sale or exchange during the taxable year.

Aaron recognizes $90,000 of gain on this transfer: $80,000 represents the FMV of the note, and $10,000 represents the excess of the liability assumed over the basis of the property transferred. Since §1239 applies to the transfer, the $10,000 gain recognized under §357(c), as well as the §80,000 gain recognized under §351(b), is taxable as ordinary income.

Corporate Property Distribution

When a corporation distributes property to its shareholder, either in a liquidating or nonliquidating distribution, it recognizes gain as if it sold the property to the shareholder at its FMV. See §336(a) and §311(b)(1).

If the corporation is a controlled entity with respect to the shareholder receiving the property distribution, the gain is subject to §1239 recharacterization.

Here is an example: Violet, Inc., an S corporation, distributes a rental property to Natalie, its 100% owner. The rental property has an FMV of $250,000: $100,000 for the land and $150,000 for the building. It has an adjusted basis of $75,000: $25,000 for the land and $50,000 for the building. The S corporation took $20,000 of depreciation deductions with respect to the building and held the rental property for more than one year.

Upon distributing the land to Natalie, Violet, Inc. recognizes $75,000 of §1231 gain, treated as a long-term capital gain. This gain is not recharacterized as ordinary income under §1239 because it is not of a character subject to §167 depreciation.

Upon distributing the building to Natalie, Violet, Inc. recognizes $20,000 of unrecaptured §1250 gain, which is capital gain subject to a maximum 25% rate, and $80,000 of §1231 gain, treated as long-term capital gain. However, §1239 applies to the building, so the entire §100,000 gain is taxable as ordinary income.

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