Section 1245 vs 1250 Depreciation Recapture

Section 1245 recapture applies to personal property and is taxed at ordinary income rates, up to 37 percent. Unrecaptured Section 1250 gain applies to real property and is capped at 25 percent. When you sell a property that has been cost segregated, the gain splits across both categories plus long term capital gain, and the mix determines your actual tax bill. Understanding the split before you sell is the difference between a planned exit and an unpleasant surprise.

The Three Buckets of Gain

Sell a depreciated building and the gain divides into three pieces, each taxed differently:

Bucket	What it covers	Federal rate
Section 1245 recapture	Depreciation on personal property: appliances, carpeting, cabinetry, fixtures, equipment	Ordinary, up to 37%
Unrecaptured Section 1250 gain	Straight line depreciation on the building and land improvements	Maximum 25%
Section 1231 gain	Appreciation above original cost basis	0, 15, or 20% long term capital gain

Net investment income tax of 3.8 percent applies on top for most high income sellers, and state tax is separate.

Why Section 1250 Is Usually Gentler Than People Expect

Full Section 1250 recapture at ordinary rates only applies to depreciation taken in excess of straight line. Since 1986, real property under MACRS is required to use straight line, so there is essentially no excess depreciation on modern buildings and true 1250 recapture is almost always zero.

What actually applies is unrecaptured Section 1250 gain under Section 1(h)(1)(E), which taxes the straight line depreciation you claimed at a maximum of 25 percent. It is technically a capital gain rate, just a higher one than the usual 15 or 20 percent.

How a Cost Segregation Study Changes the Mix

This is the tradeoff nobody explains clearly when selling a study. Reclassifying components into 5 year property produces a much larger deduction now, and moves that same depreciation from the 25 percent bucket into the ordinary income bucket on exit.

A $2,000,000 property held five years, sold for $2,400,000:

	No study	With cost segregation
Depreciation claimed	$290,000	$780,000
1245 recapture at 37%	$0	$300,000, tax $111,000
Unrecaptured 1250 at 25%	$290,000, tax $72,500	$480,000, tax $120,000
1231 gain at 20%	$400,000, tax $80,000	$400,000, tax $80,000
Tax at sale	$152,500	$311,000
Tax saved during hold at 37%	$107,300	$288,600
Net across the hold	-$45,200	-$22,400

The study still wins, and that ignores five years of using the money. But the sale year tax is roughly double, and the seller who was not told this ahead of time is the one who ends up angry. Figures are illustrative; the mix depends on allocation, hold period, and rates.

Six Ways to Manage the Recapture

Do not sell. A 1031 exchange defers the entire amount. Chain exchanges and hold until death, and the Section 1014 basis step up can eliminate it for your heirs.
Use a partial asset disposition. When you replace a roof or parking lot, elect to write off the remaining basis of the old component. That reduces the depreciation later subject to recapture. See partial asset disposition.
Time the sale into a low income year. 1245 recapture is taxed at ordinary rates, so it is highly bracket sensitive. Selling in a retirement or sabbatical year can move it several brackets.
Use an installment sale for the 1231 portion. Note that Section 1245 recapture is not eligible for installment treatment under Section 453(i) and is recognized entirely in the year of sale, even if you receive nothing that year. This surprises people badly.
Offset with suspended passive losses. A fully taxable disposition frees suspended losses under Section 469(g), which can absorb a large part of the gain. See passive activity loss rules.
Allocate the purchase price thoughtfully. The buyer wants basis in short life assets, you want gain in the 1231 bucket. It is a negotiated allocation reported by both parties on Form 8594, and it must be consistent.

Where This Shows Up on the Return

Sales of business and rental property are reported on Form 4797. Section 1245 recapture is computed in Part III and carries to Part II as ordinary income. Section 1231 gain flows to Schedule D. Unrecaptured Section 1250 gain is tracked on the Unrecaptured Section 1250 Gain Worksheet and taxed through the Schedule D tax computation. If a single sale is misreported as a simple capital gain, the error is usually visible in the absence of a Form 4797 entirely.

The Planning Point

Recapture is not a reason to avoid cost segregation. Deferral has real value, and for most investors the present value math favors accelerating. But the exit needs to be modeled at the same time as the entry, not five years later when the property is already under contract. See what happens to depreciation when you sell.

Frequently Asked Questions

What is the difference between Section 1245 and Section 1250 property?

Section 1245 property is depreciable personal property, including appliances, carpeting, cabinetry, fixtures, machinery, and equipment. Section 1250 property is depreciable real property, meaning buildings and their structural components along with land improvements. The distinction matters at sale, because depreciation on 1245 property is recaptured at ordinary income rates while depreciation on 1250 property is generally taxed as unrecaptured Section 1250 gain at a maximum of 25 percent.

What is the tax rate on depreciation recapture?

Section 1245 recapture is taxed at ordinary income rates, which can reach 37 percent federally. Unrecaptured Section 1250 gain is taxed at a maximum rate of 25 percent. Gain above your original cost basis is Section 1231 gain taxed at long term capital gain rates of 0, 15, or 20 percent. The 3.8 percent net investment income tax may apply on top, and state tax is separate.

Does cost segregation increase depreciation recapture?

It changes the character of the recapture rather than creating more of it. By reclassifying components into 5, 7, and 15 year property, a study moves depreciation that would have been taxed at a maximum of 25 percent into the Section 1245 category taxed at ordinary rates. Total depreciation over the hold is similar, but more of it is recaptured at higher rates on sale. The accelerated deduction usually still wins on a present value basis, but the exit should be modeled up front.

Can you avoid depreciation recapture?

You can defer it or eliminate it in certain ways. A 1031 exchange defers recapture into the replacement property. Holding until death gives heirs a stepped up basis under Section 1014, which eliminates the deferred gain and recapture. Suspended passive losses released on a fully taxable disposition can offset the gain. Timing a sale into a low income year reduces the rate on the ordinary portion. Simply selling in a normal year does not avoid it.

Is depreciation recapture eligible for installment sale treatment?

No. Under Section 453(i), Section 1245 depreciation recapture must be recognized in full in the year of sale, regardless of how much cash you receive that year. Only the remaining Section 1231 gain can be spread across installment payments. Sellers who structure a seller financed sale without accounting for this can owe substantial tax in year one with very little cash collected.

Section 1245 vs Section 1250 Recapture: What You Actually Owe on Sale