Section 1239 provides gain on the sale or exchange of certain depreciable property between related taxpayers is taxed at ordinary income rates rather than the more typical capital gain or unrecaptured 1250 gain rates. Section 1239 applies to property that, in the hands of the transferee, is subject to depreciation under Section 167. It includes depreciable real property as well as depreciable intangibles. Section 1239 discourages related taxpayers from taking advantage of the tax arbitrage between depreciation deductions that can offset ordinary income and more favorable capital gains rates that might otherwise be available on the sale of such depreciable property. Without Section 1239, related taxpayers might continuously sell or exchange depreciable property to repeatedly depreciate the property. Section 1239 removes that tax arbitrage strategy.

Section 1239 applies only where the exchange is between parties who are related. Section 1239(b) provides “related persons” means (1) a person and all entities that are controlled entities by such person, (2) a taxpayer and any trust of which the taxpayer (or his or her spouse) is a beneficiary, and (3) except for a sale or exchange in satisfaction of a pecuniary bequest, an executor of an estate and a beneficiary of the estate.

This article discusses only the first of these definitions. “Controlled entity” is defined in Section 1239(c)(1) to mean, with respect to any person, (1) a corporation more than 50 percent of which is owned (directly or indirectly) by or for such person, (2) a partnership more than 50 percent of the capital interests or profits interests of which is owned (directly or indirectly) by or for such person, and (3) any entity that is related to such person under Section 267(b). Section 1239(c)(2) provides for the purpose of determining whether an entity is considered a controlled entity, the attribution rules of Section 267(c) apply (other than Section 267(c)(3)).

Under Section 267(c), ownership of stock can be attributed through corporations, partnerships, estates, or trusts. Additionally, an individual is treated as owning stock owned directly or indirectly by or for his family. Family means “brothers and sisters (whether by the whole or half blood), spouses, ancestors, and lineal descendants.” Stock attribution can result in a shareholder’s being treated as owning more than 50 percent of the value of the outstanding equity interests of the business, which makes them related persons under Section 1239.

Section 1239 can be particularly important in the case of family-owned businesses because, where shareholders are relatives, the stock attribution rules of Section 267 may require they be treated as related to the family business. In that case, any sales or exchanges between the business and the related shareholder is subject to Section 1239, even where such shareholder does not control the business.

A distribution of depreciable property from a business in liquidation of an equity holder’s interest is considered a sale or exchange from the perspective of the business. That can trigger the application of Section 1239 if the recipient is a related person.

John G. Hodnette is an attorney with Fox Rothschild in Charlotte.

October 16, 2023/by TAX