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Recapture can be a confusing subject. I'll try to demystify it a bit, at least as it relates to REITs. I'll also show why unit holders in REITs shouldn't worry about recapture too much. In a future article, I can discuss recapture in the MLP context, which differs slightly.

Recapture: An Overview

What is recapture, first of all? It's a tax term that refers to income (and corresponding tax) that is meant to "recapture" a tax benefit that you received in the past. Recapture often occurs upon sale of an asset. For example, suppose you own a depreciable lawn mower, which you use in your landscaping business. You take depreciation deductions each year on the lawn mower. These deductions reduce the lawn mower's basis. Then, one year, you decide to sell the lawn mower. Assume that you will sell it at a gain, and that some of the gain is due to the reduced basis (rather than the lawn mower appreciating in value). Normally, you would realize capital gains on the sale (and pay taxes at the capital gains rate). But here, upon sale of the lawn mower, you might "recapture" part of the gain. This gain is due to the decreased basis, which resulted from the depreciation deductions. If recapture applies, you might pay taxes at a rate higher than the long-term capital gain rate on part of the gain. This way, you will "pay back" some or all of the deductions you took in prior years. Recapture does not necessarily cancel out the prior tax benefit. Even if you received a $100 deduction in Year 1, and recaptured $100 of gain in Year 5, you still benefited from the time value of money--the theoretical compounding of the $100 you saved in Year 1, over five years, until you pay back $100 in Year 5. As long as the deduction and the "recapture" were not in the same year, you still come out ahead (theoretically).

Recapture and REITs

If you take a look at your 1099-DIV, which is the tax form usually associated with REITs, you will notice Box 2b. It lists "Unrecaptured Section 1250 Gain." You may scratch your head, and wonder: (1) What is "Unrecaptured Section 1250 Gain?" and (2) What happens to the Unrecaptured Section 1250 Gain? and (3) What is happening to the Section 1250 Gain that is recaptured?

Let's answer these questions, one-by-one:

(1) What is "Unrecaptured Section 1250 Gain?"

Section 1250 Gain is the gain that is due to the depreciation deductions having reduced the property's basis and that is not recaptured on the sale of the property. A REIT usually owns real estate, which it uses in its business. For example, W.P. Carey Inc. (NYSE:WPC) and Lexington Realty Trust (NYSE:LXP) own commercial buildings, which they lease to corporate tenants. As the REIT holds a building, it will take depreciation deductions on the building each year. When the REIT decides to sell the building (it must "dispose" of the building to trigger recapture, per I.R.C. 1250(a)(1)(A)), a portion of the gain may result in "Section 1250 Gain." This gain is meant to recapture some, but not all, of the gain that results from the depreciation deductions (which reduced the real property's basis). The portion that is not recaptured is called, "Unrecaptured Section 1250 Gain."

(2) What happens to the unrecaptured gain?

Unrecaptured Section 1250 Gain is taxed at a 25% rate. When the REIT distributes the profits from the sale to unit holders, part of the distributions will be taxed at the 25% rate rather than at the lower, capital gains rate. Box 2b shows the amount of distributions that faced this tax treatment in the current, taxable year.

(3) What is happening to the Section 1250 gain that is recaptured?

If recaptured, Section 1250 Gain will be taxed at ordinary rates. In reality, however, unit holders in REITs that invest predominantly in real property should have little reason to worry about recapture. Assuming the REIT held the real property for over one year before selling it, the only portion of gain that is subject to recapture is the portion of depreciation that is in excess of straight-line depreciation (I.R.C. 1250(a), (b)). But both non-residential real property and residential real property are depreciable via the straight-line depreciation method (I.R.C. 168(b)(3)). This means that there will be no depreciation that is in excess of straight line depreciation, and, so, no portion that will be subject to recapture. Given this, REITs that hold mostly real property shouldn't generate much recapture upon disposition of the property. And for those REITs that might face recapture, they'll likely take advantage of other parts of the Code, such as like-kind exchanges under Section 1031, to defer gain and to avoid triggering recapture.

Conclusion

Recapture isn't necessarily a tax nightmare for REITs, and unit-holders likely shouldn't spend too much time worrying about recaptured gain. True, Unrecaptured 1250 Gain may result in a 25% tax rate on some portions of the distributions. True, the sale of non-real property (such as "clean fuel vehicles" and "certain refueling property" under Section 179A) might be subject to recapture. But in general, the tax advantages of REITs, and the various tax moves the REIT can do to avoid incurring too much Section 1250 Gain, should provide enough solace for unit holders.

Source: Why You Shouldn't Worry About Recapture With REITs

Additional disclosure: This communication is for informational purposes only. As of this writing, the author is not an attorney or a certified financial planner. Any U.S. Federal Tax advice contained in this communication is not intended or written to be used, and cannot be used, for avoiding penalties under the internal revenue code or promoting, marketing or recommending to another party any tax-related matters addressed herein. This post is not intended as a solicitation or endorsement for legal services, and all data and all information is not warranted as to completeness and are subject to change without notice and without the knowledge of the author.