Section 1255 Property: What Are the Recapture Rules?

When selling property associated with a farm or business, tax consequences can extend beyond standard capital gains. A rule known as recapture may require you to treat a portion of your gain as ordinary income, effectively “paying back” a tax benefit you previously received. The principle is to prevent a double benefit where a taxpayer excludes a government payment from income and also receives preferential capital gains treatment on the property improved with those funds.

Identifying Qualifying Property and Payments

Property is subject to recapture rules, detailed in Internal Revenue Code Section 1255, under a two-part test. First, the property must have been acquired, improved, or otherwise modified using funds from government-sponsored, cost-sharing conservation programs.

The second requirement is that the payments received from these programs must have been partly or wholly excluded from your gross income under IRC Section 126. This tax exclusion directly triggers the potential for future recapture. Examples of programs that provide such excludable payments include those for soil and water conservation, forestry improvement projects, or habitat restoration efforts. If you excluded a payment from your income, any property improved with those funds is considered Section 1255 property.

Calculating the Recapture Amount

The amount to be recaptured as ordinary income is the smaller of two figures: the total gain you realize from the sale of the property, or the total cost-sharing payments you excluded from income for that property. The gain realized is the selling price minus your adjusted basis in the property. The adjusted basis is not increased by the value of the excluded payments.

This initial figure is multiplied by an applicable percentage determined by how long you held the property after receiving the excludable payment. If you dispose of the property within ten years, the applicable percentage is 100%. For every full year you hold the property beyond the ten-year mark, this percentage decreases by 10%. For instance, a disposition in the 12th year would result in an 80% applicable percentage.

To illustrate, assume you sold a piece of qualifying farmland for a gain of $50,000. You had previously received and excluded $30,000 in government payments for conservation improvements on that land. The lesser of these two amounts is $30,000. If you sold the property seven years after receiving the payment, the applicable percentage is 100%, and you would recapture the full $30,000 as ordinary income. If you sold it 15 years later, the percentage would be 50% (100% minus 50% for the five extra years), and you would recapture $15,000 ($30,000 x 50%). After holding the property for 20 years, the applicable percentage drops to zero, and no recapture is required.

Reporting the Property Disposition

Once you have determined that your property is subject to recapture and have calculated the final recapture amount, you must report the transaction to the IRS. The disposition is reported on Form 4797, Sales of Business Property.

The amount you calculated as recapture is entered in Part III of Form 4797, which treats the amount as ordinary income. If your total gain on the sale exceeds the amount you recaptured, the excess gain is carried over to Part I of the form. This remaining gain is generally reported as a Section 1231 gain, which may receive more favorable long-term capital gain treatment.