Recapture – A Dirty Word In Tax Code Lingo

Overview

In 1972, comedian George Carlin listed in a monologue the “Seven Words You Can Never Say on Television.”  He then proceeded to use all seven words multiple times.  The use of those words constitutes a violation of Federal Communications Commission standards and triggers a penalty.  In the tax world, there are also “dirty” words, and they are used to describe something that happens in tax that triggers a bad tax result for the taxpayer.  “Recapture” is one of those words.  It means that a tax benefit previously received must be given up – paid back. That “pay back” is often at ordinary income tax rates rather than the (often) more favorable capital gain rates.

Recapture in the context of depletion deductions previously claimed that is associated with oil and gas interests – it’s the topic of today’s post.

Recapture – What Is It?

At its core, recapture is the Code’s procedure for triggering income on a gain a taxpayer realizes upon the disposition of an asset that had previously provided a tax benefit, such as through depreciation.  Because depreciation can be deducted from ordinary income to reflect the wear-and-tear on an asset (an exhaustion factor) used in the taxpayer’s trade or business or for the production of income where the asset has a determinable useful life of more than one year, gain on the disposal of the asset (up to the taxpayer’s recomputed basis in the asset (see, e.g. I.R.C. §1016 and/or I.R.C. §1245(a)(2)(A)) must be reported as ordinary income.  It is not reported as capital gain in accordance with I.R.C. §1231.  Depreciation recapture attributable to tangible personal property is governed by I.R.C. §1245.  The provision governing recapture associated with real property is I.R.C. §1250.  For I.R.C. §1250 recapture purposes, the IRS refers to it as “additional depreciation” in IRS Pub. 544.  In I.R.S. Pub. 544, the IRS describes it as the portion of accumulated depreciation that exceeds straight line depreciation.  It is taxed at ordinary income rates to the extent of gain realized at a maximum of 37 percent (presently).  The portion corresponding to straight-line depreciation is “unrecaptured §1250 gain” and is taxed at a maximum rate of 25 percent.  Any remaining gain is long-term capital gain if the taxpayer had held the property for over a year, and is taxed at a maximum capital gain rate of 20 percent. 

Depletion Deduction Recapture

There’s another recapture section of the Code – I.R.C. §1254.  It’s titled, “Gain from disposition of interest in oil, gas, geothermal, and other mineral properties.”  While gain on the sale or exchange of natural resources is generally capital gain in nature via I.R.C. §1221 or I.R.C. §1222 or via the netting process of I.R.C. §1231, I.R.C. §1254 taxes as ordinary income the recapture of depletion deductions previously claimed when an oil or gas interest is disposed of in a taxable transaction.  Under I.R.C. §1254, the amount recaptured as ordinary income is the lesser of (1) the sum of the deductions for depletion under I.R.C. §611 that reduced the property’s adjusted basis, and the intangible drilling and development costs currently deducted under I.R.C. §263; or (2) the gain obtained by deducting the adjusted basis of the property from the amount realized.  I.R.C. §§1254(a)(1)(A),(B). 

Because I.R.C. §1254 applies to depletion that reduces adjusted basis, it applies to both percentage and cost depletion – to the extent either depletion approach reduced the adjusted basis of the subject property.  Thus, gain in excess of depletion previously allowed is taxed as ordinary income.  It also applies separately to each property of the taxpayer, if the taxpayer has more than a single property.  I.R.C. §614 defines “property” for this purpose.  Also, if the taxpayer only disposes of a portion of a property that is subject to I.R.C. §1254 depreciation recapture, rules governing partial dispositions can apply.  See I.R.C. §1254(a)(2); Treas. Reg. §1.1254-1(c). 

Consider the following example:

Suzy, in 2011, acquired a working interest in an oil and gas deposit.  Her original basis in the interest was $100,000.  During Suzy’s period of ownership, she was allowed (and claimed) $75,000 of depletion deductions.  Thus, her adjusted basis in the working interest is $25,000 in accordance with I.R.C. §1016(a)(2).  Suzy did not expense any intangible drilling and development costs.  Suzy later sells her working interest in the deposit in 2019 for $125,000 - its fair market value at the time of sale.  Suzy has realized gain of $125,000 less her adjusted basis of $25,000, or $100,000.  Applying I.R.C. §1254(a)(1), Suzy has recapture of the previously claimed depletion deductions of the lesser of $75,000 or $100,000.  Thus, $75,000 of the $100,000 gain is treated as ordinary income.  The remaining $25,000 gain is taxed as long-term capital gain in accordance with I.R.C. §1231. 

Other Rules on Recapture

As noted above, recapture is potentially triggered when the taxpayer’s interest is disposed of in a taxable transaction.  In other words, there must be a “disposition” of the asset before recapture is possible.  Some transactions do not constitute a “disposition” for purposes of recapture under I.R.C. §1254.  These include mortgaging the property (Treas. Reg. §1.1254-1(b)(3)(ii)(A)); any abandonment (unless the taxpayer recognizes income on the foreclosure of a nonrecourse debt) (Treas. Reg. §1.1254-1(b)(3)(ii)(B)); leasing or subleasing the property (Treas. Reg. §1.1254-1(b)(3)(ii)(C)); the termination or election of S corporation status (Treas. Reg. §1.1254-1(b)(3)(ii)(D)); including the property in a pooling or unitization arrangement (Treas. Reg. §1.1254-1(b)(3)(ii)(E)); the expiration or reversion of an operating mineral interest in whole or in part by the terms of the agreement (Treas. Reg. §1254-1(b)(3)(ii)(F)); or any conversion of an overriding royalty interest that at the grantor’s option (or at the option of a successor in interest) converts to an operating mineral interest after a certain amount of production.  Treas. Reg. §1.1254-1(b)(3)(ii)(G).  Also, when taxpayers exchange their interests in oil and gas partnerships for stock of a newly organized corporation, they don’t have any gain or loss except to the extent that their share of partnership liabilities exceed their basis.  In this situation, there is no recapture of intangible drilling costs.  Priv. Ltr. Rul. 8107099 (Nov. 21, 1980). 

If the disposition of the oil or gas (or geothermal) property is by gift, recapture is not triggered.  Treas. Reg. §1.1254-2(a)(1).  But if the transaction is a part gift/part sale transaction (typically utilized in estate planning situations and other transactions involving family members) recapture can apply to any gain that the transaction triggers.  Treas. Reg. §1.1254-2(a)(2).  The charitable deduction associated with a gift to a charitable organization of a working or operating interest in an oil or gas property must be reduced by the amount of any intangible drilling and development costs attributable to the donated interest that the donor previously deducted under I.R.C. §1254.  I.R.C. §170(e)(1)(A).   

As usual, a transfer on account of death does not trigger recapture.  Treas. Reg. §1.1254-2(b).  Also, if the disposition occurs as part of a like-kind exchange under I.R.C. §1031, the depreciation recapture taxed as ordinary income is limited to the “boot” (gain attributable to “unlike” property) involved in the exchange.  Treas. Reg. §1.1254-2(c).  On this last point, it appears to be implicit in the regulation that an interest in an oil and gas property constitutes real estate for purposes of I.R.C. §1031.  That’s an important point now that personal property is not eligible for tax-deferred treatment under I.R.C. §1031.

When a partnership disposes of an interest in oil and gas (or other natural resources), the amount treated as ordinary income is determined at the partner level.  Each partner recognizes as ordinary income the lesser of the partner’s I.R.C. §1254 costs with respect to the property disposed of, or the partner’s share of the amount (if any) by which the amount realized upon the sale, exchange, or involuntary conversion, or the fair market value of the property upon any other disposition, exceeds the adjusted basis of the property.  Treas. Reg. §1.1254-5(b)(1). 

Conclusion

Oil and gas taxation is a bit unique in many respects.  Depletion, while conceptually the same as depreciation, is nuanced.  The rules on recapture of the depletion deduction generally follow the rules for depreciation recapture.  That means if the rules are triggered, the result is not going to be a good one for the taxpayer.  Remember, “recapture” is one of the “dirty” words in tax.  Avoid it if you can.