Depreciation Recapture on Rental Property: Sections 1245, 1250, and the 25% Rate
Depreciation can produce valuable tax deductions while rental property or business property is owned. Those deductions also reduce the property's adjusted tax basis, which can increase the taxable gain when the property is eventually sold.
The tax consequences are commonly described as depreciation recapture, but that phrase can oversimplify the actual rules. Section 1245 can convert gain into ordinary income. Section 1250 can also produce ordinary income in certain circumstances. In addition, individual taxpayers selling depreciated real estate can have unrecaptured Section 1250 gain that remains long term capital gain but is subject to a maximum federal income tax rate of 25 percent.
A real estate sale can therefore produce several tax categories at the same time. The result becomes more complex when the property has a cost segregation study, accelerated depreciation, an installment sale, a Section 1031 exchange, prior Section 1231 losses, or suspended passive losses.
For broader guidance on rental property taxation, dispositions, passive activity rules, and other investor issues, see my Real Estate Tax Planning resource page.
Key Tax Takeaways
- Depreciation generally reduces adjusted tax basis and can increase taxable gain when property is sold.
- Section 1245 commonly applies to equipment, furniture, appliances, and certain assets identified through cost segregation.
- Section 1245 generally treats gain as ordinary income to the extent required by the statutory recapture calculation.
- Section 1250 applies to depreciable real property other than Section 1245 property.
- For many post 1986 residential and commercial buildings depreciated under MACRS, ordinary Section 1250 recapture from regular building depreciation is generally zero.
- Individual taxpayers can still have unrecaptured Section 1250 gain associated with depreciation on real estate.
- Unrecaptured Section 1250 gain is not ordinary income and is not automatically taxed at 25 percent. It is long term capital gain subject to a maximum federal rate of 25 percent.
- Section 1245 and Section 1250 ordinary recapture income generally must be recognized in the year of an installment sale.
- Unrecaptured Section 1250 gain can generally be recognized as installment gain is reported rather than being accelerated entirely into the year of sale.
- A Section 1031 exchange does not eliminate the need to analyze Sections 1245 and 1250.
- A sale to certain related persons can cause all recognized gain to be ordinary income under Section 1239.
- Corporations can be subject to an additional Section 291 recapture rule on Section 1250 property.
What Is Depreciation Recapture?
Depreciation recapture refers generally to tax rules that change the character of gain because depreciation or similar deductions were previously allowed with respect to an asset.
The basic economic issue is straightforward. Depreciation reduces taxable income while an asset is owned. It also generally reduces the asset's adjusted tax basis. When the asset is later sold for more than its adjusted basis, the Internal Revenue Code may characterize part of the gain differently from the gain that would otherwise arise from the property sale.
The two principal federal recapture provisions relevant to rental and business property are Sections 1245 and 1250.
| Rule | Typical Property | Potential Result |
|---|---|---|
| Section 1245 | Equipment, furniture, appliances, and other qualifying depreciable property | Gain can be recharacterized as ordinary income |
| Section 1250 | Depreciable real property that is not Section 1245 property | Additional depreciation can produce ordinary income recapture |
| Unrecaptured Section 1250 gain | Long term gain associated with depreciation on Section 1250 property | Long term capital gain potentially subject to a maximum 25 percent federal rate for individuals |
Depreciation Recapture and Unrecaptured Section 1250 Gain Are Not the Same Thing
The phrase depreciation recapture is often used informally to describe all gain attributable to prior real estate depreciation. Technically, ordinary income recapture under Section 1250 and unrecaptured Section 1250 gain under Section 1(h)(6) are different tax concepts.
That distinction matters because one amount is ordinary income while the other remains long term capital gain subject to a separate maximum rate.
How Does Depreciation Increase the Gain When Rental Property Is Sold?
Gain is generally measured by comparing the amount realized on the disposition with the property's adjusted tax basis.
Section 1016 requires basis to be adjusted for depreciation. For relevant periods, the basis reduction generally cannot be less than the depreciation that was allowable.
Example: Depreciation Reduces Adjusted Basis
Assume a depreciable asset has an original tax basis of $500,000. During the ownership period, $180,000 of depreciation is allowed or otherwise required to reduce basis.
Ignoring other basis adjustments, the adjusted basis becomes $320,000.
If the asset is later sold for a net amount realized of $600,000, the tax gain is $280,000, not $100,000.
The $180,000 of depreciation reduced taxable income during the ownership period but also reduced the basis used to calculate gain at disposition.
Can Property Be Sold for Less Than Its Original Cost and Still Produce Taxable Gain?
Yes.
Assume an asset originally cost $500,000 and depreciation reduced its adjusted basis to $300,000. If it is later sold for $400,000, the taxpayer has a $100,000 tax gain even though the selling price is $100,000 below the original cost.
This is one reason an estimate based only on purchase price and selling price can materially understate the tax from a property sale.
What Is Section 1245 Depreciation Recapture?
Section 1245 applies to specified depreciable or amortizable property. Personal property is a major category, but the statutory definition is broader than simply movable equipment.
Depending on the particular asset, Section 1245 property can include:
- Furniture
- Appliances
- Machinery
- Business equipment
- Vehicles
- Certain qualifying building components
- Certain improvements depending on their federal tax classification
- Other property specifically included within Section 1245
Section 1245(a)(1) generally treats the applicable gain as ordinary income. The amount is determined separately for each item of Section 1245 property.
In simplified terms, ordinary income treatment generally applies to the extent the gain represents recovery of depreciation or amortization reflected in the statutory recomputed basis, subject to the detailed rules and limitations of Section 1245.
Example: Section 1245 Asset Sold at a Gain
Assume rental property furniture originally cost $40,000 and has been fully depreciated, producing an adjusted basis of zero.
The furniture is later sold for $15,000.
The taxpayer has a $15,000 gain. Because the gain is within the applicable depreciation amount, the $15,000 is generally ordinary income under Section 1245.
What if the Section 1245 Asset Is Sold for More Than Its Original Basis?
Section 1245 ordinary income treatment is limited by its statutory calculation. Gain exceeding the applicable recapture amount can retain the character that would otherwise apply.
Example: Gain Exceeds Prior Depreciation
Assume equipment originally cost $100,000 and has an adjusted basis of $40,000 after $60,000 of depreciation. The equipment is sold for $130,000.
The total gain is $90,000.
In a simplified example, the first $60,000 can be ordinary income under Section 1245 because it represents the prior depreciation amount. The remaining $30,000 must then be characterized under the other applicable disposition rules.
How Do Bonus Depreciation and Section 179 Affect Recapture?
Accelerated deductions can reduce an asset's adjusted basis quickly, which can increase the amount of gain when the asset is later sold.
Section 1245 expressly takes various depreciation and amortization adjustments into account, and specified Section 179 deductions are treated as amortization for purposes of the recapture computation.
Bonus depreciation does not by itself determine whether an asset is Section 1245 property. Classification depends on the nature of the underlying property. When the underlying property is Section 1245 property, however, accelerated depreciation can increase the prior depreciation relevant to the later disposition analysis.
Accelerated Depreciation Is a Timing Benefit
Bonus depreciation and Section 179 can provide substantial current deductions. The complete analysis should also consider the expected holding period, sale value, tax rate during ownership, future recapture, and whether the current deduction is limited by other tax rules.
What Is Section 1250 Property?
Section 1250 generally applies to depreciable real property other than property classified as Section 1245 property.
For a real estate investor, Section 1250 property commonly includes the depreciable building and structural components that remain part of the building for federal depreciation purposes.
Land itself is not Section 1250 property because land is not depreciable.
How Does Ordinary Section 1250 Recapture Work?
For property held more than one year, Section 1250 ordinary income treatment generally focuses on additional depreciation, meaning depreciation exceeding the amount that would have been determined using the straight line method.
The current Form 4797 instructions provide that Section 1250 recapture does not apply to specified residential rental and nonresidential MACRS real property placed in service after 1986.
As a result, an individual who sells a typical post 1986 residential rental building that has been depreciated using the required straight line MACRS method will often have no ordinary Section 1250 recapture from the regular building depreciation.
This does not mean prior depreciation has no effect on the sale.
What Is Unrecaptured Section 1250 Gain?
Unrecaptured Section 1250 gain is a separate category of long term capital gain under Section 1(h)(6).
In simplified terms, it generally captures the portion of qualifying long term gain associated with depreciation on Section 1250 property that was not already treated as ordinary income.
For individual taxpayers, unrecaptured Section 1250 gain is subject to a maximum federal income tax rate of 25 percent.
The 25 Percent Rate Is a Maximum Rate, Not an Automatic Flat Tax
It is common to hear that rental property depreciation is recaptured at 25 percent. That statement is not technically precise.
Unrecaptured Section 1250 gain remains long term capital gain. Section 1(h) places it within a maximum 25 percent rate category for individuals. The actual tax imposed on that gain can be lower depending on the taxpayer's taxable income and the interaction with the capital gain rate calculation.
Unrecaptured Section 1250 Gain Is Also Limited by the Section 1231 Calculation
When the Section 1250 property is property described in Section 1231, Section 1(h)(6)(B) limits the relevant amount to the taxpayer's net Section 1231 gain for the taxable year.
The Schedule D calculation can impose additional limitations based on the taxpayer's other long term gains and losses.
This means the potential unrecaptured Section 1250 gain from one building cannot always be determined in isolation from the taxpayer's other Section 1231 transactions and capital gains and losses.
Example: Typical Rental Building Sale
Assume a rental building has an original depreciable basis of $500,000 and $150,000 of straight line depreciation has been claimed. The adjusted building basis is $350,000.
Assume the net amount realized properly allocated to the building is $700,000. The total building gain is $350,000.
If the building is typical post 1986 MACRS real property and no ordinary Section 1250 recapture applies, up to $150,000 of the gain associated with prior depreciation can enter the unrecaptured Section 1250 gain calculation.
The final amount is still subject to the applicable Section 1231 and Schedule D calculations. The remaining qualifying gain can potentially fall within the other long term capital gain rate categories.
What if I Never Claimed Depreciation on the Rental Property?
Failing to claim depreciation does not generally allow a taxpayer to preserve the property's original tax basis indefinitely.
Section 1016(a)(2) generally requires the basis adjustment for depreciation to be no less than the amount allowable. As a result, adjusted basis can be reduced for depreciation that should have been claimed even when the deduction was omitted from the tax return.
The detailed recapture calculation has its own statutory rules, including the Section 1245 provisions concerning depreciation allowed or allowable and the ability in certain circumstances to establish the amount actually allowed with adequate records.
The key planning point is that simply failing to deduct depreciation is not a reliable method for avoiding tax consequences when the property is later sold.
Missing Depreciation Should Be Identified Before the Property Is Sold
If prior returns failed to claim allowable depreciation, the depreciation history should be reconstructed before calculating the sale. The correct adjusted basis and the appropriate method for addressing omitted depreciation should be determined separately rather than assuming the original basis remains available.
How Does Cost Segregation Affect Depreciation Recapture?
A cost segregation study separates portions of a building project into assets with different federal tax classifications and recovery periods.
Some components may be classified as Section 1245 property for depreciation purposes while the building structure remains Section 1250 property. Other improvements require classification based on the specific asset and applicable tax rules.
The IRS Cost Segregation Audit Techniques Guide illustrates that individual building and site components can have different Section 1245 or Section 1250 classifications.
| Property Component | Potential Disposition Issue |
|---|---|
| Land | Not depreciable and therefore not subject to depreciation recapture |
| Building structure | Generally Section 1250 property |
| Furniture and equipment | Generally Section 1245 property |
| Appliances | Generally Section 1245 property |
| Cost segregation components | Section 1245 or Section 1250 treatment depends on the federal tax classification of the individual asset |
| Other site or building improvements | Classification must be determined from the particular asset and applicable rules |
A Cost Segregation Study Can Produce Several Types of Gain in One Sale
When an entire real estate property is sold, the transaction may need to be divided among the individual tax assets rather than treating the property as one undifferentiated building.
The sale can potentially include:
- Gain or loss on land
- Section 1245 ordinary income recapture
- Section 1250 ordinary income recapture when applicable
- Unrecaptured Section 1250 gain
- Remaining Section 1231 gain or loss
- Potential Section 1231 lookback recharacterization
The amount realized must be allocated among the separate assets using supportable values. Form 4797 generally requires separate treatment of the assets involved in the disposition.
Keep the Cost Segregation Study Through the Sale
A cost segregation study is not merely support for the depreciation deduction in the year it is performed. The asset level classifications and depreciation schedule can become essential when the property is later sold or exchanged.
If you are evaluating accelerated depreciation on a property, see the Cost Segregation Calculator and Real Estate Resources.
How Does Depreciation Recapture Interact With Section 1231?
Depreciation recapture is generally determined before the remaining qualifying gain enters the Section 1231 netting process.
Section 1245 ordinary income recapture does not receive favorable Section 1231 gain treatment. The remaining gain or loss is then analyzed under the other applicable rules.
For Section 1250 property, any ordinary recapture is similarly determined before the remaining gain enters the Section 1231 calculation.
After the annual Section 1231 netting calculation, the five year lookback rule can convert additional net Section 1231 gain into ordinary income.
For the complete disposition framework, see Section 1231 Tax Rules: Selling Rental Property and Business Real Estate .
For the prior loss rule specifically, see Section 1231 Lookback Rule: How Prior Losses Can Turn Gain Into Ordinary Income .
One Sale Can Produce Several Different Tax Categories
Assume a real estate property includes land, a depreciable building, and Section 1245 assets identified through a prior cost segregation study.
The Section 1245 assets may generate ordinary income recapture. The building may generate unrecaptured Section 1250 gain. Remaining qualifying gain can enter the Section 1231 calculation, where the five year lookback rule may convert additional gain to ordinary income.
A single capital gain percentage therefore cannot accurately estimate the federal tax on the sale.
Can an Installment Sale Defer Depreciation Recapture?
An installment sale can defer some gain, but it generally does not defer ordinary depreciation recapture under Sections 1245 and 1250.
Section 453(i) requires recapture income to be recognized in the taxable year of disposition. For this purpose, recapture income generally means the amount that would be ordinary income under Section 1245 or Section 1250 if all payments were received in the year of sale.
Gain exceeding that ordinary recapture amount can generally be taken into account under the installment method if the transaction otherwise qualifies.
Example: Section 1245 Recapture in an Installment Sale
Assume a property sale generates $300,000 of total gain, including $60,000 of Section 1245 ordinary income recapture.
Section 453(i) generally requires the $60,000 recapture amount to be recognized in the year of sale even though a substantial portion of the selling price will not be collected until future years.
The remaining eligible gain can potentially be recognized as installment payments are received.
Unrecaptured Section 1250 Gain Has a Different Installment Rule
Unrecaptured Section 1250 gain is not the ordinary recapture income described in Section 453(i).
The current Schedule D instructions specifically address installment sales of Section 1250 property. In general, the gain included in each installment payment is treated first as unrecaptured Section 1250 gain until the remaining unrecaptured Section 1250 gain from the sale has been used.
Accordingly, ordinary Section 1245 or Section 1250 recapture and unrecaptured Section 1250 gain should not be treated as though they have the same installment sale timing.
Seller Financing Can Create a Cash Flow Mismatch
A seller may receive only a portion of the sales proceeds during the closing year while still being required to recognize all applicable ordinary depreciation recapture immediately.
Before agreeing to an installment sale, the first year tax liability should be compared with the cash actually expected to be received at closing.
Does a Section 1031 Exchange Avoid Depreciation Recapture?
A qualifying Section 1031 exchange can defer gain, but it does not make the Sections 1245 and 1250 rules irrelevant.
Section 1031 currently applies to qualifying real property held for productive use in a trade or business or for investment that is exchanged for like kind real property to be held for a qualifying purpose.
Sections 1245(b)(4) and 1250(d)(4) contain specific rules coordinating depreciation recapture with transactions in which gain is not recognized in whole or in part under Section 1031.
Section 1031 Real Property Classification Is a Separate Test
Treasury Regulation Section 1.1031(a)-3 contains a specific definition of real property for Section 1031.
Importantly, the regulation states that its real property classification applies only for Section 1031. It does not control whether the same asset is Section 1245 or Section 1250 property for depreciation and recapture purposes.
An asset can therefore be real property for purposes of Section 1031 while also being Section 1245 property for depreciation recapture purposes.
This Is Particularly Important After Cost Segregation
The current Form 8824 instructions provide an example involving an apartment building for which part of the basis had previously been allocated to Section 1245 assets. The example illustrates that property can qualify as real property for Section 1031 while the taxpayer must still perform a Section 1245 recapture analysis.
The classification of both the relinquished property and the replacement property therefore matters. A Section 1031 exchange should not be assumed to defer every depreciation related amount merely because the overall transaction qualifies as an exchange of real property.
Review the Fixed Asset Schedule Before Starting the Exchange
When property has undergone cost segregation, the depreciation schedule should be reviewed before the exchange is structured. The analysis should identify Section 1245 and Section 1250 components, their adjusted bases, the nature of the replacement assets, and any gain that may remain recognizable.
What Happens if Depreciable Property Is Sold to a Related Person?
Section 1239 can produce a result that is more severe than the ordinary Section 1245 and Section 1250 recapture rules.
When depreciable property is sold or exchanged between persons related within the meaning of Section 1239, any gain recognized by the transferor is treated as ordinary income if the property is of a character subject to depreciation in the hands of the transferee.
The statute includes controlled corporations and partnerships and certain other relationships within its related person rules.
Example: Sale to a Controlled Entity
Assume an individual sells appreciated depreciable real estate to an entity that is a controlled entity with respect to that individual under Section 1239. The property will remain depreciable in the purchasing entity's hands.
If Section 1239 applies, all recognized gain on the transaction can be treated as ordinary income. The taxpayer should not assume that gain exceeding ordinary depreciation recapture will automatically receive Section 1231 or capital gain treatment.
Related Party Transfers Require Separate Analysis
Moving appreciated real estate between an owner and a controlled corporation or partnership can have consequences that are very different from a sale to an unrelated buyer. Section 1239 should be reviewed before the transfer terms are finalized.
Are Depreciation Recapture Rules Different for Corporations?
They can be.
Section 291(a)(1) contains an additional rule for corporations disposing of Section 1250 property.
The provision generally treats as ordinary income 20 percent of the excess of the amount that would have been ordinary income if the property were Section 1245 property over the amount otherwise treated as ordinary income under Section 1250.
This can create ordinary income even when the regular Section 1250 calculation for a typical straight line depreciated building would otherwise produce little or no ordinary recapture.
Section 1363(b)(4) can also cause Section 291 to apply to an S corporation if the S corporation or a predecessor was a C corporation during any of the three immediately preceding taxable years.
Do Not Apply the Individual 25 Percent Discussion to a C Corporation
The unrecaptured Section 1250 gain rate rules discussed above are part of the individual capital gain rate structure under Section 1(h). A corporation holding real estate requires a separate entity level analysis, including Section 291 when applicable.
Land Is Not Subject to Depreciation Recapture
Land is not depreciable. Gain allocable to land is therefore not Section 1245 or Section 1250 depreciation recapture merely because the land is sold together with a depreciable building.
When land and depreciable improvements are sold together, the amount realized must be allocated between the assets using supportable values.
The allocation affects the gain on the land, the gain on the building, the potential unrecaptured Section 1250 gain, and any separate Section 1245 assets.
Do Not Allocate the Entire Sales Price to One Asset
A sale of real estate that includes land, a building, furniture, equipment, and cost segregation components may require several separate gain calculations. The closing statement alone may not provide the tax allocation needed for Form 4797.
How Do Suspended Passive Losses Affect the Sale?
Depreciation recapture determines the character of gain from the disposition. The passive activity rules answer a different question: whether suspended losses can become deductible.
Under Section 469(g), a qualifying disposition of an entire passive activity to an unrelated person in a transaction in which all realized gain or loss is recognized can release suspended passive losses from the normal passive activity limitation.
As a result, the property sale can simultaneously generate depreciation related gain and release prior rental losses.
For a detailed discussion, see Suspended Passive Rental Losses: Four Ways Real Estate Investors Can Use Them .
Model Both Sides of the Sale
A meaningful property sale projection should calculate the gain and recapture while also determining whether suspended passive losses become available. Reviewing only one side of the transaction can materially misstate the expected taxable income.
Where Is Depreciation Recapture Reported?
Form 4797, Sales of Business Property, is the principal federal form used to report dispositions of depreciable business property and calculate ordinary income under Sections 1245 and 1250.
Depreciable property sold at a gain generally enters Part III of Form 4797 so the applicable recapture calculation can be performed.
Amounts remaining after the recapture calculation can then flow into the applicable Section 1231 reporting process.
Unrecaptured Section 1250 gain for individuals is coordinated through the Schedule D Unrecaptured Section 1250 Gain Worksheet.
Installment sales can also require Form 6252, and qualifying like kind exchanges generally require Form 8824.
What Should Be Reviewed Before Selling Depreciated Real Estate?
A preclosing depreciation recapture analysis should generally identify:
- The property's original acquisition basis
- The allocation between land and depreciable property
- Capital improvements made during ownership
- Depreciation allowed or allowable
- Any missed depreciation from prior years
- Section 179 deductions
- Bonus depreciation
- Any cost segregation study
- Each material Section 1245 asset and its adjusted basis
- Section 1250 building basis and depreciation
- Assets previously disposed of or replaced
- The expected selling price and selling costs
- A supportable allocation of the amount realized among land, building, and other assets
- Potential Section 1245 ordinary income recapture
- Potential Section 1250 ordinary income recapture
- Potential unrecaptured Section 1250 gain
- Current year Section 1231 gains and losses
- Nonrecaptured Section 1231 losses from the preceding five years
- Suspended passive losses associated with the activity
- Installment sale terms if seller financing is being considered
- Section 1031 treatment if an exchange is being considered
- Related party issues under Section 1239
- Corporate recapture rules when the property is held in a corporation
- Potential net investment income tax
- Applicable state income tax consequences
This analysis is most useful before the transaction closes because the amount and timing of the tax can influence the economic terms of the sale, the amount of cash needed for estimated taxes, and the decision between a taxable sale, installment sale, or qualifying exchange.
Frequently Asked Questions About Depreciation Recapture
What is depreciation recapture on rental property?
Depreciation recapture generally refers to rules that change the character of gain when depreciated property is disposed of. Section 1245 can create ordinary income on qualifying depreciable property. Section 1250 can create ordinary income in certain circumstances, while depreciation on Section 1250 real estate can also contribute to unrecaptured Section 1250 gain.
Is rental property depreciation recapture taxed at 25 percent?
Not exactly. For many post 1986 rental buildings depreciated using straight line MACRS, ordinary Section 1250 recapture from regular building depreciation is generally zero. Instead, part of the long term gain can be unrecaptured Section 1250 gain. For individuals, that category is subject to a maximum federal income tax rate of 25 percent rather than a mandatory flat 25 percent tax.
What is the difference between Section 1245 and Section 1250?
Section 1245 generally applies to specified depreciable or amortizable property, including personal property and certain other assets. Section 1250 generally applies to depreciable real property that is not Section 1245 property. The two sections use different ordinary income recapture rules.
What is unrecaptured Section 1250 gain?
Unrecaptured Section 1250 gain is a category of long term capital gain generally associated with depreciation on Section 1250 property that was not otherwise treated as ordinary income. For individuals, it can be subject to a maximum federal rate of 25 percent. It is not the same as ordinary Section 1250 depreciation recapture.
What happens if I did not claim depreciation on my rental property?
Section 1016 generally requires adjusted basis to reflect depreciation allowable even when the taxpayer failed to claim the deduction. The depreciation history should therefore be reconstructed before calculating the property sale rather than assuming the omitted depreciation preserved the original basis.
Can I have taxable gain if I sell property for less than I originally paid?
Yes. Depreciation and other basis adjustments can reduce adjusted basis below the eventual sales price even when the property sells for less than its original cost.
How does cost segregation affect depreciation recapture?
Cost segregation can separate property into assets with different federal tax classifications. Some components may be Section 1245 property while the building remains Section 1250 property. When the property is sold, those components can require separate gain and recapture calculations.
Can an installment sale defer depreciation recapture?
Section 453(i) generally requires ordinary recapture income under Sections 1245 and 1250 to be recognized in the year of disposition. Gain exceeding the ordinary recapture amount may qualify for installment reporting. Unrecaptured Section 1250 gain is not the ordinary recapture income accelerated by Section 453(i) and is generally allocated to installment gain as payments are reported.
Does a Section 1031 exchange avoid depreciation recapture?
Not automatically. Sections 1245 and 1250 contain specific coordination rules for like kind exchanges. In addition, an asset can qualify as real property for Section 1031 purposes while still being classified as Section 1245 property for depreciation purposes. The relinquished and replacement asset classifications must be reviewed to determine whether any recapture is currently recognized or carried into the replacement property.
Is land subject to depreciation recapture?
No. Land is not depreciable, so gain allocable to land is not depreciation recapture under Sections 1245 or 1250. When land and depreciable improvements are sold together, the amount realized must be allocated among the assets.
What happens if depreciable property is sold to a related party?
Section 1239 can treat all recognized gain as ordinary income when depreciable property is sold or exchanged between persons related under that section and the property is depreciable in the transferee's hands. The related party rules should therefore be reviewed separately from the normal depreciation recapture calculation.
Are the rules different if a corporation owns the real estate?
Yes. Section 291 can impose additional ordinary income treatment on a corporation disposing of Section 1250 property. Section 291 can also apply to certain S corporations that were C corporations, or had a predecessor that was a C corporation, during any of the three immediately preceding taxable years.
Where is depreciation recapture reported on a tax return?
Form 4797 is generally used to calculate and report Section 1245 and Section 1250 ordinary income from business property dispositions. Unrecaptured Section 1250 gain for individuals is coordinated through Schedule D. Installment sales can also require Form 6252, and like kind exchanges generally require Form 8824.
Final Takeaway
Depreciation can create substantial tax savings while rental property or business property is owned, but the tax consequences do not end when the depreciation deduction is claimed.
When the property is sold, the depreciation history affects adjusted basis and can determine whether gain is ordinary income under Section 1245 or Section 1250, unrecaptured Section 1250 gain subject to the special capital gain rate structure, or remaining Section 1231 gain.
Cost segregation, bonus depreciation, Section 179, installment sales, Section 1031 exchanges, related party transactions, corporate ownership, prior Section 1231 losses, and suspended passive losses can each change the result.
The depreciation schedule should therefore be reviewed before the property is sold, not after the closing has already occurred. A preclosing analysis can identify the expected ordinary income, capital gain categories, tax timing, and cash required for the resulting federal and state tax liabilities.
Calculate Depreciation Recapture Before the Property Is Sold
I assist real estate investors and business owners with preclosing depreciation recapture analysis. The review can include reconstruction of adjusted basis and depreciation, cost segregation components, Section 1245 and Section 1250 classification, ordinary income recapture, unrecaptured Section 1250 gain, Section 1231 lookback exposure, suspended passive losses, installment sale terms, Section 1031 alternatives, entity ownership, and state tax consequences.
The objective is to determine the expected tax result before closing so the transaction can be evaluated using the actual after tax economics while planning alternatives remain available.
Schedule a ConsultationThis article provides general federal income tax information. Depreciation recapture and property disposition treatment depend on the asset's tax classification, adjusted basis, depreciation history, holding period, ownership structure, transaction terms, related party relationships, prior tax elections, and other facts. State income tax treatment can differ from federal treatment.
