If you’re thinking about investing in commercial real estate, you may have come across the term “section 1245 property.” But what is a section in real estate?
The Internal Revenue Service (IRS) defines any asset that depreciates or amortizes as a 1245 property. Investing can be a great way to generate income and build wealth over time. However, it’s important to understand how this type of investment works before you jump in. Here’s what you need to know about what is a section in real estate.
What is a Section in Real Estate?
A section in real estate refers to a designated area of land that has been subdivided into smaller, more manageable pieces. Sections are typically created by developers and then sold off to individual buyers.
The size of a section can vary greatly, but they are typically large enough to accommodate a few homes.
What is a Section 1245 Property?
According to the Internal Revenue Code, any asset that is depreciable or amortized is considered a 1245 property.
Section 1245 properties do not include buildings or structural components.
The following are classified as 1245 properties:
- The property plays a key role in the manufacturing, extraction, transportation, communications, electric, gas, and water supply for business operations.
- The facility can be used for any of the purposes listed in the first item.
- The property stores fungible commodities in bulk.
A fungible commodity is any physical good that can be traded for equal quantities of the same product like oil.
Now that we know a little more about 1245 properties, let’s take a look at some examples of what these properties can look like.
Section 1245 isn’t necessarily real estate in the traditional sense. It can refer to an asset that plays an integral role in your business operations, from specific pieces of equipment to company cars.
To get a better sense of what types of assets are considered a 1245 asset, let’s look at some examples of what those might be.
- Business vehicles
- Machines for manufacturing goods
- Blast furnaces
- Storage bins for grain (fungible)
- Copyright or trademarks
While we’ve seen examples of 1245 properties outside of the realm of the real estate market, it’s important not to confuse these with other types of property.
Let’s take a look at some examples of what is NOT considered section 1245 properties.
- Components of an office, factory, or building such as lighting, HVAC, or plumbing systems
- Fencing for livestock
- Water troughs for livestock
- Business inventory held for sale
The items above are permanent fixtures that are attached to the land and cannot be removed.
While section 1245 property is considered personal, it’s used exclusively for business purposes.
For example, the pantry fridge is not considered Section 1245 property. While offering comfort to employees, the IRS considers it more of a luxury than a necessity for business operations.
A company vehicle, on the other hand, is necessary to distribute products to businesses. As a result, this is an example of a section 1245 asset.
How Does Section 1245 Property Impact Taxation?
You’re probably already aware that 1245 properties are a great way to lower your tax bill. But do you know why?
One strategy to reduce your business’ tax burden is to claim deductions for equipment that depreciates over time. This can be a helpful way to lower your overall tax liability.
As many assets depreciate over time due to wear and tear, it’s suggested that business owners capitalize on this when filing taxes for a Section 1245 property.
To fully understand how 1245 property is taxed, you must understand depreciation.
The 1245 and 1250 sections of US tax law were designed to prevent companies from claiming a tax deduction on an asset, which offsets their ordinary business revenue, while simultaneously paying less tax on any profits made from selling that asset.
This accounting method is beneficial in terms of saving money when filing taxes for your business, but there is a significant trade-off involved.
Depreciating assets is a great way to save on taxes, but there’s a huge tradeoff.
If you sell a capital loss, then you’ll pay extra taxes. This is because your losses will be “recaptured” and taxed as capital gains.
Now that we’ve discussed why it’s important to depreciate assets under Section 1245, let’s take a look at how that can affect your tax return.
Assuming that the value of any asset is depreciating can be just as foolish as not noticing that the value of that asset is declining.
You may owe taxes on the 1245 property if:
- You sell the 1245 asset for profit
- The property was depreciated
- You held onto this property for more than one year.
If all three conditions are met, then the asset will classify as a 1245 property and be subject to a 50% tax rate.
If you have a 1245 property, you will be subject to Depreciation Recapture. This means the total amount of taxes you deducted for your property will be recaptured and added to your income. The rest of your sales price will be taxable at 1231 rates.
1231 properties are those that are used for business or investment purposes and have been held for more than one year.
All Section 1250 property, which is a property that has been fully depreciated, can be classified as a 1231 property. However, there may be some special circumstances where it makes sense to explore this classification further.
If you sell the property for a loss and it’s considered a 1231 asset, then you won’t have to worry about any tax consequences.
Now let’s see how this will work in a real-life scenario.
Let’s assume that you purchase a $200 tool. You then take $150 of depreciating it.
Now, let’s say you’re selling the tool for $250.
The amount you depreciated ($150) is taxed at a higher ordinary income tax rate, while the remaining $50 is taxed at a lower rate for 1231 properties.
What if you priced your tool lower than the price you purchased it for? Now your gain would be $0 and the depreciation recapture rule wouldn’t apply here.
One of the primary factors that will affect your 1245 gain is the profit you make when you sell the property.
The simplest way to prevent depreciation recapture is to not claim any losses on it. If you have properties that are considered 1245, then don’t deduct any expenses on depreciating them when you file your taxes.
As long as those properties are depreciated, they will remain 1231 assets and not 1245. That also means you’ll owe more in taxes upfront. But you won’t have to worry about paying taxes if you decide to sell them later on.
Before you can claim depreciation on any 1245 asset, make sure you’re aware of the tax implications. Think about these questions:
- Would your rather save money this year or later down the road?
- Do you plan on selling your 1245 assets at some point?
- Will assets be unsalvageable?
One way to avoid the tax man from coming after you is by selling your depreciating asset for a lower amount. If you’re selling, then don’t sell for capital gain.
You’ll probably make a lower profit on the deal, but you won’t have to pay as much in taxes.
As a small business owner, it’s essential to keep all your invoices and documents organized. Having these documents readily available will help make preparing and submitting your tax returns easier.
But, of course, selling a devalued asset for capital gain is quite rare. After all, an asset that has lost value over time is, by definition, a diminished one. Since it’s older, it may not function as well as it did when first purchased.
If you’re considering refurbishing an asset to sell it for a higher price, you may want to think twice if doing so will trigger depreciation recapture.
What is a section in real estate? A section 1245 property is a type of personal property that is used for business operations and can be depreciated for tax purposes. If you’re thinking about buying or selling a section 1245 property, make sure you do your research first so that you know what you’re getting into.