Section 291: Corporate Preference Items and Real Estate Recapture

Under Section 291 of the Internal Revenue Code, a C corporation that sells depreciable real property must treat 20% of the depreciation that would have been recaptured as ordinary income under the Section 1245 rules as ordinary income, even though the regular Section 1250 rules would treat none of it that way. Section 291 recapture also reduces four other corporate tax preferences: percentage depletion on coal and iron ore, intangible drilling and mining development costs, pollution control facility amortization, and financial institution preference items. The real estate rule is the one most corporations run into, and it catches returns every year.

Which Corporations It Applies To

Section 291 applies to C corporations, meaning entities that file Form 1120 and pay tax at the entity level.¹ S corporations, partnerships, LLCs taxed as partnerships, and individuals are not.

There is one carryover to watch. An S corporation that was itself a C corporation, or whose predecessor was a C corporation, during any of the three immediately preceding tax years remains subject to Section 291.² This blocks the maneuver of electing S status right before selling appreciated real estate. Once three full tax years have passed under the S election with no C corporation history, the exposure ends.

How the Real Estate Recapture Is Calculated

To see why Section 291 exists, start with how depreciation recapture works elsewhere. Sell depreciable personal property such as equipment, and every dollar of depreciation you claimed comes back as ordinary income under Section 1245. Real property is different. Section 1250 only recaptures depreciation that exceeded straight-line, and since virtually all real property placed in service after 1986 is depreciated straight-line under MACRS, that excess is almost always zero. Without Section 291, a corporation selling a modern commercial building would pay no ordinary income recapture at all.

Section 291 partially closes that gap. It requires the corporation to recognize, as ordinary income, 20% of the amount by which a hypothetical Section 1245 recapture would exceed the actual Section 1250 recapture.¹ The remaining 80% stays as Section 1231 gain, eligible for capital gains treatment at the corporate level.

The mechanics in three steps:

Figure the gain that would be ordinary income if the building were Section 1245 property. For straight-line depreciation, that equals total depreciation claimed, capped at the gain.
Figure the gain that is actually ordinary income under the regular Section 1250 rules. For post-1986 straight-line property, this is almost always zero.
Subtract the second figure from the first and multiply by 20%. The result is additional ordinary income.

A worked example. A C corporation sells a commercial building for a $500,000 gain after claiming $300,000 of straight-line depreciation. Regular Section 1250 recapture: $0. Hypothetical Section 1245 recapture: $300,000. The difference is $300,000. Section 291 adjustment: 20% of $300,000, or $60,000 of ordinary income. The other $440,000 of the gain is Section 1231 gain.

That $60,000 shift matters because ordinary income is taxed at the full corporate rate, while Section 1231 gains net against Section 1231 losses and can flow through to the corporation’s capital gain treatment for the year.

Reporting on Form 4797

The Section 291 adjustment is reported on Form 4797, Sales of Business Property, at Line 26f. The instructions define the amount as 20% of the excess of what would be ordinary income if the property were Section 1245 property over what is actually ordinary income under the regular Section 1250 rules.³ For a corporation using straight-line depreciation, Line 26f is simply 20% of the total depreciation that would have been recaptured under a Section 1245 analysis.

Leaving Line 26f blank on a return that reports a real estate disposition is one of the more common corporate return errors. The amount flows into ordinary income, and skipping it means underpayment.

Like-Kind Exchanges and Other Nonrecognition Transactions

The statute’s language sounds absolute. It says the Section 291 ordinary income “shall be recognized notwithstanding any other provision of this title.”¹ Read only that sentence and you would think a like-kind exchange triggers Section 291.

The next sentence pulls back. Section 291 does not apply where Section 1250(a) itself does not apply because of Section 1250(d). Section 1250(d) covers the standard nonrecognition transactions: like-kind exchanges under Section 1031, involuntary conversions, and certain corporate reorganizations. A C corporation that swaps one commercial building for another in a properly structured 1031 exchange does not trigger Section 291 recapture on the deferred gain. The recapture obligation carries over to the replacement property and comes due when the corporation eventually sells in a taxable transaction.

The Other Preference Items

Real estate is the common trigger, but Section 291 also cuts four other tax benefits.

Percentage Depletion on Coal and Iron Ore

For corporations mining coal, including lignite, or iron ore, the percentage depletion deduction is reduced by 20% of the amount by which the deduction exceeds the property’s adjusted basis at year-end.¹ If depletion does not exceed adjusted basis, there is no reduction.

Intangible Drilling and Mining Development Costs

Deductions for intangible drilling and development costs under Section 263(c), and for mining exploration and development costs under Sections 616 and 617, are cut by 30%.¹ The 30% is not lost. It is deducted ratably over 60 months beginning with the month the costs were paid or incurred.

The 30% cut on intangible drilling costs applies only to integrated oil companies, defined as crude oil producers disqualified from the independent producer percentage depletion allowance under Section 613A(d). The reduction on mining costs under Sections 616 and 617 applies to all corporations.

Pollution Control Facility Amortization

When a corporation elects rapid amortization of a certified pollution control facility under Section 169, the amortizable basis is reduced by 20%.¹ Only 80% of the cost runs through the accelerated schedule. The remaining 20% is recovered through regular depreciation over the property’s useful life.

Financial Institution Preference Items

Banks and other financial institutions face a 20% reduction in the deduction for financial institution preference items.¹ The main target is the interest expense a bank incurs to carry tax-exempt bank-qualified bonds under the Section 265(b) exception.

Effect on Earnings and Profits

Section 291 also increases Earnings and Profits, the measure that determines whether a distribution to shareholders is a taxable dividend or a non-taxable return of capital. For the real estate recapture, the full amount of Section 291 ordinary income is reflected in E&P. That means a corporation cannot sell appreciated real estate, apply the preference items to shelter the gain, and then push the cash out to shareholders tax-free. The higher E&P pulls future distributions into dividend treatment.

Penalty Exposure for Getting It Wrong

Missing Section 291 costs more than the additional tax. The accuracy-related penalty is 20% of the underpayment attributable to negligence or a substantial understatement of income tax.⁴

For corporations other than S corporations and personal holding companies, a substantial understatement exists when the understatement exceeds the lesser of 10% of the tax required to be shown on the return (or $10,000, whichever is greater) and $10,000,000.⁵ A single large building sale can push a missed Section 291 adjustment past that threshold on its own. Negligence in this context includes any failure to make a reasonable attempt to comply with the code, and disregard covers careless or reckless handling of the rules.⁴ Not knowing about Section 291 is unlikely to help a corporation that filed Form 4797 for a real property sale with Line 26f left blank.

The practical safeguard is treating the Section 291 calculation as a standard checklist item on every corporate sale of depreciable real property, on every return claiming coal or iron ore percentage depletion, on every intangible drilling or mining development deduction, on every Section 169 amortization election, and on every bank return with tax-exempt interest deductions.

1
Office of the Law Revision Counsel. 26 USC 291 – Special Rules Relating to Corporate Preference Items
2
Office of the Law Revision Counsel. 26 USC 1363 – Effect of Election on Corporation
3
Internal Revenue Service. Instructions for Form 4797
4
Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments
5
Internal Revenue Service. Accuracy-Related Penalty