Rev. Rul. 72-141

Advice has been requested whether, under the circumstances described below, a taxpayer's recognized gain on the sale of certain machinery and equipment is to be treated as ordinary income under section 1245 of the Internal Revenue Code of 1954.

The taxpayer uses the calendar year as its taxable year. Some of its depreciable machinery and equipment were accounted for in item accounts and some were accounted for in group accounts in accordance with section 1.167(a)-7 of the Income Tax Regulations. All items of its machinery and equipment are similar and have similar useful lives to the taxpayer. The taxpayer uses the straight line method to calculate its depreciation deduction for all of its machinery and equipment accounts (item and group).

For 1962 and each subsequent year through 1967, the taxpayer chose to have the depreciation claimed on its machinery and equipment examined under the depreciation guidelines of Revenue Procedure 62-21, C.B. 1962-2, 418. To facilitate comparison of the lives used by the taxpayer with the guideline life and as permitted by section I, Part II of the Procedure, the taxpayer, in 1962 permanently regrouped all such machinery and equipment into one multiple asset account corresponding to the appropriate guideline class and determined a 12-year class life for the account to which it applied an average rate of 8.33 percent.

The taxpayer, continued to use the straight line method of calculating depreciation for the regrouped machinery and equipment account. Machinery and equipment acquired during 1962, 1963 and 1964 were added to the account (an "open-end" account).

Part III, Section 2.01 of Revenue Procedure 65-13, C.B. 1965-1, 759, provides that, if, in a taxable year, any asset in a guideline class acquired after the "first limitation year" (which is 1965 in the instant case) has for tax purposes been recorded by a taxpayer in an open-end multiple asset account and the taxpayer's depreciation deduction for such account is calculated under either the straight line or sum-of-the-years-digits method, then the depreciation deduction for such guideline class for such taxable year shall be examined without regard to Revenue Procedure 62-21 or Revenue Procedure 65-13. However, Revenue Procedure 65-13, Part III, Section 2.02, provides that this limitation shall have no application to any guideline class, if all assets in such class acquired during or after the first limitation year have been recorded in year of acquisition accounts or item accounts, or if the depreciation deduction for such assets that are recorded in open-end multiple asset accounts is calculated under the declining balance method.

In view of Revenue Procedure 65-13, after 1964, no additions to the account were made (the open-end account was "closed") and all machinery and equipment acquired after 1964 have been accounted for in year of acquisition accounts, so that the taxpayer was not precluded from continuing to be examined under Revenue Procedure 62-21.

The closed account (formerly the open-end account) became fully depreciated to zero in 1966.

From 1961 until the account became fully depreciated, the taxpayer credited the account's depreciation reserve with the salvage proceeds from its normal retirement sales under the provisions of section 1.167(a)-7 and section 1.167(a)-8(e)(2) of the regulations.

Section 1245(a)(1) of the Code provides in part that, if "section 1245 property" (which includes depreciable personal property such as machinery and equipment) is disposed of during a taxable year beginning after December 31, 1962, the amount by which the lower of the recomputed basis of the property, or the amount realized by sale, exceeds the adjusted basis of such property shall be treated as gain from the sale of property that is neither a capital asset nor property described in section 1231 of the Code. Such gain shall be recognized, notwithstanding any other provisions relating to gains.

Section 1.1245-2(a)(6) of the regulations, relating to the allocation of the adjustments to periods after December 31, 1961, provides that only the depreciation for periods after December 31, 1961, shall be treated as reflected in the adjusted basis for purposes of determining recomputed basis.

Section 1.1245-6(a) of the regulations further provides that, since section 1245 of the Code overrides section 1231 of the Code, the gain recognized under section 1245(a)(1) of the Code upon a disposition will be treated as ordinary income and only the remaining gain, if any, from the disposition may be considered as gain from the sale of a capital asset if section 1231 of the Code is applicable.

Since section 1245 of the Code overrides section 1231 of the Code, the ordinary income determined under section 1245 of the Code on an asset retired by sale after 1962 must be based on the amount of the depreciation taken on the asset after 1961 and reflected in the adjusted basis for determining the recomputed basis of the asset. Where such depreciation exceeds the gain realized on the sale, all of the gain realized is ordinary income under section 1245 of the Code. Where such depreciation is less than the gain realized on the sale, the gain realized is ordinary income under section 1245 of the Code only to the extent of such depreciation and the remaining realized gain, if any, is governed by the provisions of section 1231 of the Code.

In the instant case for each disposition, the adjustment for depreciation allowed or allowable after 1961 for determining ordinary income under section 1245 of the Code should be made at the rate that would have been proper had the asset been depreciated in a single asset account under the straight line method of depreciation, based on the average expected useful life of the asset (the rate used for that item in arriving at the rate used for the account, for the guideline class), for the period that the asset was included in the closed (formerly open-end) account from December 31, 1961, to the time the account became fully depreciated to zero in 1966.

An asset transferred into a multiple asset account loses its identity for purposes of calculating depreciation. Appendix IV, of the Revenue Procedure 62-21, Announcement 63-97, I.R.B. 1963-38, 18, (Internal Revenue Service Publication No. 456, Revised August 1964, 91). However, when the depreciation reserve account equals the cost or other basis of the asset account, such account is fully depreciated and no further depreciation is allowable on that account; therefore, gains must be reported on all retirement dispositions. See Revenue Ruling 70-168, C.B. 1970-1, 47. The ordinary income under section 1245 of the Code depends upon the gain realized from the sale and the depreciation allowed or allowable after 1961 for the asset sold after December 31, 1962.

Accordingly, the gain recognized from the salvage proceeds on the sale of each item of machinery and equipment by the taxpayer from the closed average rate multiple asset account, after the account became fully depreciated in 1966, is ordinary income under section 1245 of the Code to the extent of the depreciation allowed or allowable after 1961 on such item.

For example, two items of machinery and equipment, originally costing $10,000 each, were both retired and sold by the taxpayer in 1967, one item for $2,500 and the other for $5,000. Both items had similar useful lives and were acquired prior to the taxpayer's adoption of Revenue Procedure 62-21 for 1962. They were included with other items of machinery and equipment that were permanently regrouped into the average rate multiple asset account, using the useful life that was used for each item (12 years, or a rate of 8.33 percent), to arrive at the class life for the account for 1962 and subsequent years.

The depreciation accrued on each item for the applicable period (5 years, 1962 through 1966, when the account became fully depreciated to zero) is $4,165 ($10,000 cost x 8.33 percent x 5 years). For the item sold for $2,500, since the depreciation of $4,165 for the applicable period exceeds the gain of $2,500 ($2,500 salvage proceeds less the basis of zero), all of the realized gain of $2,500 is ordinary income under section 1245 of the Code. However, for the item sold for $5,000, since the gain of $5,000 ($5,000 salvage proceeds less the basis of zero) exceeds the depreciation of $4,165 for the applicable period, $4,165 of the realized gain of $5,000 is ordinary income under section 1245 of the Code; the remaining recognized gain of $835 ($5,000 less $4,165) is governed by the provisions of section 1231 of the Code.