Depreciation Recapture Tax: Section 1245, 1250, and Real Estate

The Tax Bill That Follows Every Depreciation Deduction

Every dollar of depreciation deducted against rental property income creates a future tax liability. Investors who claim $50,000 in depreciation on a rental property over five years and sell at a gain do not simply pay capital gains tax on the profit — they also pay recapture tax on that $50,000 at rates that can reach 25% for real estate and 37% for equipment. Understanding recapture before selling — not after — determines whether a sale strategy makes financial sense.

Two Recapture Regimes: Section 1245 and Section 1250

The tax code creates fundamentally different recapture rules depending on the type of property depreciated.

Section 1245 Property (Personal Property and Equipment)

Section 1245 applies to depreciable personal property — machinery, equipment, vehicles, furniture, and certain intangibles. When you sell Section 1245 property at a gain, the IRS recaptures all accumulated depreciation as ordinary income, regardless of the seller's tax bracket. There is no preferential rate.

Example: A business buys equipment for $100,000, claims $60,000 in depreciation, and sells for $80,000. Adjusted basis = $40,000. Gain = $40,000. But $40,000 is less than the $60,000 of accumulated depreciation, so the entire $40,000 gain is recaptured as ordinary income under Section 1245. If the business owner is in the 32% bracket, the tax is $12,800 — far higher than a 15% capital gains tax of $6,000 would have been.

Section 1250 Property (Real Property)

Section 1250 applies to depreciable real property — buildings, commercial structures, residential rental properties, improvements. The mechanics are more nuanced and generally more favorable than Section 1245.

Under current law, real estate placed in service after 1986 must be depreciated using the straight-line method (27.5 years for residential rental; 39 years for commercial). Since there is no accelerated depreciation in excess of straight-line, there is technically no Section 1250 recapture in the traditional sense for post-1986 property. However, Congress created a replacement: unrecaptured Section 1250 gain, which captures straight-line depreciation at a maximum tax rate of 25% — higher than the typical long-term capital gains rate but lower than ordinary income rates.

How Unrecaptured Section 1250 Gain Works

When a residential rental property or commercial building is sold at a gain, the gain is divided into layers:

1. Depreciation-related gain (unrecaptured Section 1250 gain): taxed at up to 25%
2. Remaining gain above original purchase price: taxed at 0/15/20% long-term capital gains rates

State taxes apply separately on top of this federal calculation. California, for example, taxes all capital gains — including recapture — at ordinary income rates up to 13.3%, with no preferential rate for long-term gains.

Installment Sale Treatment

An installment sale allows the seller to spread gain recognition over multiple tax years as payments are received, under Section 453. However, recapture income cannot be spread — Section 1245 recapture and unrecaptured Section 1250 gain must be recognized in full in the year of sale, regardless of how the payments are structured.

• Only the portion of gain above recapture can be spread over installment payments
• This means the first year of an installment sale often carries a disproportionately large tax burden
• Subsequent year payments are taxed at the preferential capital gains rate on the remaining gain portion
• Installment sales with related parties are subject to additional rules to prevent tax deferral abuse

For a seller with $109,091 in unrecaptured Section 1250 gain and $150,000 in remaining gain who takes a 5-year installment note: the entire $109,091 recapture is taxed in year one, while the $150,000 of remaining gain can be spread across the five payment years.

The 1031 Exchange: Deferring Recapture Indefinitely

A Section 1031 like-kind exchange defers both the capital gain and the depreciation recapture on real property. Rather than paying tax in the year of sale, you roll the deferred gain and recapture into the basis of the replacement property. The accumulated liability compounds across properties but is never triggered unless you sell without doing another 1031 exchange.

• Identification rule: New property must be identified within 45 days of closing the sale
• Closing rule: Replacement property must close within 180 days of the sale
• Boot: Cash or non-like-kind property received in an exchange is taxable in the year of the exchange, including recapture income on the boot portion
• Death benefit: At the investor's death, heirs receive a stepped-up basis to fair market value, eliminating both the accumulated capital gain and the recapture liability — effectively making 1031 exchanges a vehicle for permanent tax elimination when held until death

Depreciation recapture is not avoidable simply by declining to claim depreciation deductions. The IRS taxes recapture on depreciation "allowed or allowable" — meaning even if you forget to claim depreciation on a rental property, you still owe recapture tax on the amount you could have claimed when you eventually sell.

This article is for informational purposes only and does not constitute financial or tax advice.