Understanding the Key Differences Between IRS Sections 1245 and 1250: A Guide to Depreciation Recapture

When selling business or investment property that has been depreciated, taxpayers need to understand how the IRS treats gains on these sales through depreciation recapture provisions. Two critical sections of the Internal Revenue Code govern this process: Sections 1245 and 1250. These provisions ensure that taxpayers who have benefited from depreciation deductions against ordinary income don't receive preferential capital gains treatment on the entire gain when selling these assets.

What is Depreciation Recapture?

Depreciation recapture is a tax provision that requires taxpayers to report as ordinary income the portion of gain attributable to depreciation previously taken on property when it is sold for a profit. This mechanism allows the IRS to "recapture" taxes after you sell business assets at a value higher than the depreciated book value that was used to reduce your taxable income in previous years.

Section 1245 Property

Definition and Scope

Section 1245 covers the applicable tax rate for gains from the sale or transfer of depreciable and amortizable property. It applies to certain types of real or tangible business property that have been held by that business for more than 12 months.

Section 1245 recapture pertains to personal property, such as machinery, equipment, and certain improvements. Under this section, any gain from the sale or disposal of personal property is recaptured as ordinary income rather than as a capital gain.

Types of Property Included

Section 1245 property generally includes: - Depreciable personal property (both tangible and intangible) - Machinery and equipment - Vehicles used in business - Certain land improvements - Other tangible property (except buildings and their structural components) used as an integral part of manufacturing, production, extraction, or utility services

Tax Treatment

Section 1245 recapture is computed as the lesser of: (1) allowable depreciation or amortization on the disposed assets, or (2) the gain realized upon the disposition. This recaptured amount is taxed at ordinary income rates, which can be as high as 37% depending on your tax bracket.

Section 1250 Property

Definition and Scope

Section 1250 property is depreciable real property (other than section 1245 property). Section 1250 recapture applies to real property, including buildings and related improvements.

Types of Property Included

Section 1250 property generally includes: - Buildings (residential and commercial) - Building components and improvements - Structures attached to buildings - Leasehold improvements to real property

Tax Treatment

When section 1250 property is sold, gain up to the amount of depreciation claimed is generally taxed at a maximum rate of 25 percent. However, there's an important distinction:

True section 1250 recapture would be taxed at ordinary income tax rates, however it's not too common since it only applies when the depreciation taken on such property was in excess of straight-line depreciation. Since most real property is depreciated using the straight-line method under current tax law, true Section 1250 recapture is relatively rare.

The more common situation is what's known as "Unrecaptured Section 1250 Gain," which is taxed at a maximum rate of 25% rather than the higher ordinary income rates that apply to Section 1245 recapture.

Key Differences Between Section 1245 and 1250

1. Property Types:
2. Section 1245: Personal property and certain real property improvements

3. Section 1250: Buildings and structural components (real property)

4. Tax Rates:

5. Section 1245: Recaptured at ordinary income tax rates (up to 37%)

6. Section 1250: Typically subject to a maximum tax rate of 25% (for "unrecaptured Section 1250 gain")

7. Depreciation Method Impact:

8. Section 1245: All depreciation is recaptured regardless of depreciation method

9. Section 1250: True recapture (at ordinary rates) only applies to the portion of depreciation that exceeds what would have been allowed under straight-line depreciation

10. Historical Context: Sections 1245 and 1250 were enacted to close the loophole that resulted from allowing depreciation deductions on assets to offset ordinary income while taxing gain from the sale of these depreciated assets as capital gains.

Tax Planning Implications

Understanding the distinction between these two sections is crucial for tax planning, especially when: - Conducting cost segregation studies - Selling business or investment real estate - Planning the timing of asset dispositions - Structuring 1031 exchanges - Considering accelerated depreciation methods

Example of Depreciation Recapture

Consider a piece of equipment purchased for $100,000: - If depreciation of $60,000 has been taken over several years (adjusted basis is now $40,000) - The equipment is later sold for $70,000 - The gain is $30,000 ($70,000 - $40,000) - Under Section 1245, the entire $30,000 gain would be recaptured as ordinary income

For a building purchased for $500,000: - If straight-line depreciation of $100,000 has been taken (adjusted basis is $400,000) - The building is later sold for $550,000 - The gain is $150,000 ($550,000 - $400,000) - Under Section 1250, $100,000 would be unrecaptured Section 1250 gain taxed at a maximum of 25% - The remaining $50,000 would be taxed at capital gains rates (typically 15% or 20%)