What Is Section 1250 Recapture in Real Estate?

Section 1250 recapture in real estate is an important tax consideration for property owners who have claimed depreciation deductions. It addresses how a portion of the gain from selling depreciable real property, such as commercial buildings or residential rental properties, is taxed. This tax rule aims to adjust the tax benefits received through depreciation when the property is eventually sold for a gain. Understanding its mechanics is essential for anyone involved in real estate transactions, as it can significantly influence the ultimate tax liability.

Understanding Depreciation on Real Property

Depreciation is an annual tax deduction allowing property owners to recover the cost of certain property used in a business or for income-producing activities. This deduction accounts for the wear and tear of the property over its useful life. For tax purposes, real property is generally depreciated using the straight-line method, which spreads the cost evenly over the asset’s recovery period.

The Internal Revenue Service sets specific recovery periods for different types of real property. For instance, residential rental property is depreciated over 27.5 years, while nonresidential real property is depreciated over 39 years. These depreciation deductions reduce the property’s adjusted basis, which is its original cost minus accumulated depreciation. While depreciation reduces current taxable income, a lower adjusted basis can result in a larger taxable gain when the property is sold.

Before the Tax Reform Act of 1986, accelerated depreciation methods were permitted for real property, allowing larger deductions in earlier years. However, for most real property placed in service after 1986, only the straight-line method is allowed. This change simplified the depreciation process for newer real estate assets. The reduction in the property’s basis due to these deductions is a central element in calculating potential recapture upon sale.

Defining Section 1250 Recapture

Section 1250 recapture is a provision in the U.S. tax code designed to reclassify a portion of the gain from the sale of certain depreciable real property. Its purpose is to prevent taxpayers from converting an ordinary income deduction (depreciation) into a lower-taxed capital gain upon the property’s sale.

The concept of “excess depreciation” is central to Section 1250. This refers to the amount of depreciation taken that exceeds what would have been allowed if the straight-line method had been used. If accelerated depreciation was used, the difference between the accelerated amount and the straight-line amount would be considered excess depreciation. This portion of the gain is subject to recapture as ordinary income.

For real property placed in service after 1986, only straight-line depreciation is typically allowed for buildings. This means there is usually no “excess depreciation” to be recaptured as ordinary income under the traditional Section 1250 definition. Instead, a different rule applies to the total depreciation taken, which is known as “unrecaptured Section 1250 gain.” This unrecaptured gain is a key aspect for most current real estate transactions.

Calculating Section 1250 Recapture

The calculation of Section 1250 recapture depends primarily on when the real property was placed in service. For properties placed in service before 1987, taxpayers often used accelerated depreciation methods, which allowed for larger deductions in the early years of ownership. In such cases, if the property is sold for a gain, the amount recaptured as ordinary income is the lesser of the recognized gain on the sale or the “excess depreciation.” Excess depreciation is computed as the total depreciation claimed minus the depreciation that would have been allowable under the straight-line method.

For instance, if a property acquired before 1987 had $100,000 of total depreciation taken, but only $70,000 would have been allowed under straight-line, the $30,000 difference is the excess depreciation. If the property sold for a gain of $50,000, then $30,000 would be recaptured as ordinary income. Any remaining gain would generally be treated as capital gain. This “true” Section 1250 recapture, taxed at ordinary income rates, is less common today due to changes in depreciation rules.

For real property placed in service after 1986, only the straight-line method is generally permitted for depreciation. Consequently, there is typically no “excess depreciation” to be recaptured as ordinary income under Section 1250. However, when such a property is sold at a gain, a portion of that gain equal to the total depreciation taken is subject to a special tax rule known as “unrecaptured Section 1250 gain.” This gain is taxed at a maximum federal rate of 25%.

For example, if a property sold for a $200,000 gain and $90,000 in depreciation was taken, $90,000 of the gain would be taxed at 25% as unrecaptured Section 1250 gain. Any gain exceeding this unrecaptured amount is then taxed at the standard long-term capital gains rates, which can be 0%, 15%, or 20% depending on the taxpayer’s income.

Events Triggering Section 1250 Recapture

Section 1250 recapture is triggered upon the disposition of depreciable real property. The most common event is the outright sale of the property for a gain. When a property that has been depreciated is sold for more than its adjusted basis, the gain attributable to that depreciation may be subject to recapture rules.

Like-kind exchanges, governed by Section 1031, generally allow for the deferral of capital gains, including depreciation recapture, if specific conditions are met. If a taxpayer exchanges one qualifying real property for another like-kind property, the potential Section 1250 recapture can be deferred. However, if the taxpayer receives “boot,” such as cash or non-like-kind property, a portion of the recapture may be recognized at the time of the exchange.

Involuntary conversions, such as those from casualty, theft, or condemnation, can also trigger Section 1250 recapture. If the proceeds are reinvested in qualifying replacement property, the recapture may be deferred. Other dispositions, such as certain gifts, can also lead to recapture. Property generally receives a stepped-up basis to fair market value upon the owner’s death, which typically eliminates any potential depreciation recapture.

Reporting and Tax Impact

Section 1250 recapture and unrecaptured Section 1250 gain are primarily reported on IRS Form 4797, “Sales of Business Property.” This form is used to report the sale or exchange of property used in a trade or business. The gain from the disposition of Section 1250 property is calculated on Form 4797, which then flows to Schedule D (Capital Gains and Losses) of the taxpayer’s income tax return.

If “excess depreciation” exists (which is rare for properties placed in service after 1986), that portion of the gain is taxed as ordinary income, subject to the taxpayer’s regular marginal tax rates. For properties placed in service after 1986, the more common “unrecaptured Section 1250 gain” (representing total depreciation taken, limited by the overall gain) is subject to a maximum federal tax rate of 25%. This 25% maximum rate is distinct from the lower long-term capital gains rates (0%, 15%, or 20%). Any gain from the sale exceeding the unrecaptured Section 1250 gain is taxed at these long-term capital gains rates.