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To achieve fairness and accuracy, an income tax system must accomplish two objectives: allow depreciation deductions for the erosion in the value of assets used to produce income, and correct errors that may result from excessive depreciation allowances. The Internal Revenue Code currently fares well in accomplishing the first objective but conspicuously fails to achieve the second.

One of the two main depreciation corrective mechanisms is embodied in Internal Revenue Code § 1250. This section requires that upon the disposition of depreciable real estate used in a trade or business, a portion of the gain that reflects the taxpayer’s prior depreciation deductions must be treated as ordinary income or, in tax parlance, “recaptured.” Recapturing gain as ordinary income is consistent with the treatment of depreciation itself, which allows ordinary deductions over the period during which the asset was used to produce income.

The problem is that § 1250 is seriously flawed. When it was initially enacted, it corrected some excessive depreciation allowances; however, under current law, it rarely applies at all. Taxpayers are thus able to achieve significant tax arbitrage windfalls: by taking generous depreciation deductions, they can shelter income subject to high ordinary tax rates while recognizing subsequent gains produced by those deductions at preferential capital gains rates.

The reform that this analysis calls for is remarkably simple: Congress should repeal § 1250 and uniformly apply the more accurate recapture rules of § 1245—which currently applies only to assets other than real estate—to all depreciable assets. Uniform depreciation recapture rules would produce a more coherent tax regime, fostering fairness, efficiency, and accuracy.

Library of Congress Subject Headings

Income tax--Law and legislation, Depreciation allowances, Capital gains tax

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