Author: Robert K Valentine Jr.
When a depreciated business asset is sold at a gain, part or all of that gain often has to be reported as ordinary income rather than the more favorable capital gain, because depreciation deductions reduced your tax bill along the way and the tax code wants some of that benefit back. This is depreciation recapture, and which rules apply, Section 1245 or Section 1250, depends entirely on what kind of property was sold. The two sections produce very different tax outcomes on the same dollar of gain, which is exactly why the distinction trips up so many business owners and even some preparers, especially when a sale involves a building with both structural and non-structural components.
What Section 1245 Property Is
Section 1245 property is, broadly, depreciable personal property and certain other specific categories of business assets: machinery, equipment, vehicles, furniture and fixtures, computers, and amortizable intangibles such as patents and acquired goodwill. It also picks up certain single-purpose agricultural or horticultural structures, storage facilities for petroleum products, and some tangible property (other than buildings and their structural components) used as an integral part of manufacturing, production, or extraction activities, even if that property happens to be housed inside a larger structure.
What Section 1250 Property Is
Section 1250 property is depreciable real property that is not Section 1245 property, most commonly buildings and their structural components: the roof, walls, plumbing, wiring, elevators, and permanent fixtures of a commercial or residential rental building. Qualified Improvement Property, interior nonstructural improvements to nonresidential buildings, also falls under Section 1250, though as discussed below it frequently gets depreciated using accelerated methods that create the very recapture problem Section 1250 is supposed to limit.
How Section 1245 Recapture Works
The Section 1245 rule is the harsher of the two, and also the simpler one to apply: on a sale of Section 1245 property, all depreciation ever claimed, whether regular MACRS, Section 179 expensing, or bonus depreciation, is recaptured as ordinary income, up to the amount of the gain. Any gain beyond the total depreciation taken (meaning the sale price exceeded the asset’s original cost) is capital gain instead.
Example: Selling Manufacturing Equipment
Asset: CNC machine, 7-year MACRS property
Original cost: $100,000.00
Accumulated depreciation (MACRS plus first-year bonus depreciation): $85,000.00
Adjusted basis: $15,000.00
Sale price: $40,000.00
| Item | Amount | Character |
|---|---|---|
| Sale price | $40,000.00 | Amount realized |
| Adjusted basis | $15,000.00 | Cost less depreciation allowed |
| Total gain | $25,000.00 | Sale price minus adjusted basis |
| Section 1245 ordinary income recapture | $25,000.00 | Entire gain, since it does not exceed the $85,000.00 of depreciation taken |
| Section 1231 capital gain | $0.00 | No gain remains once recapture is applied |
Now suppose the same machine instead sold for $110,000.00. Total gain would be $95,000.00. Because accumulated depreciation was $85,000.00, only $85,000.00 of the gain is recaptured as ordinary income; the remaining $10,000.00, representing appreciation above the machine’s original cost, is Section 1231 gain eligible for capital gain treatment.
How Section 1250 Recapture Works
Section 1250 recapture only reaches “additional depreciation,” meaning the excess of the accelerated depreciation actually claimed over what straight-line depreciation would have produced. Since 1986, real property placed in service under MACRS has generally been required to use straight-line depreciation. With no accelerated component, there is usually no excess to recapture, and no Section 1250 ordinary income recapture at all on a straightforward building sale.
That does not mean the depreciation taken on the building goes untaxed at sale. Instead, the portion of gain attributable to straight-line depreciation is taxed as “unrecaptured Section 1250 gain,” a special category subject to a maximum federal rate of 25% for individual taxpayers, rather than the standard 0%, 15%, or 20% long-term capital gain rates. It is not ordinary income, but it is not taxed as favorably as ordinary long-term capital gain either.
Example: Selling a Rental Building
Asset: Commercial rental building, 39-year MACRS straight-line, building only (land excluded)
Original cost: $500,000.00
Accumulated straight-line depreciation: $120,000.00
Adjusted basis: $380,000.00
Sale price: $600,000.00
| Item | Amount | Character |
|---|---|---|
| Sale price | $600,000.00 | Amount realized |
| Adjusted basis | $380,000.00 | Cost less depreciation allowed |
| Total gain | $220,000.00 | Sale price minus adjusted basis |
| Section 1250 ordinary income recapture | $0.00 | No excess of accelerated over straight-line depreciation exists |
| Unrecaptured Section 1250 gain | $120,000.00 | Equal to depreciation taken; taxed at a maximum 25% rate |
| Remaining long-term capital gain | $100,000.00 | Appreciation above original cost; taxed at standard 0%, 15%, or 20% rates |
The Bonus Depreciation Trap Inside a Building Sale
The clean result above assumes the entire building was depreciated on a straight-line basis. That assumption breaks down whenever a cost segregation study has reclassified part of the building, such as certain electrical, plumbing, or interior components, as Section 1245 personal property with a much shorter recovery period, or when Qualified Improvement Property inside the building was placed in service and depreciated using 100% bonus depreciation. Those components were not depreciated straight-line at all; bonus depreciation is about as accelerated as it gets. When the building is later sold, gain allocated to those reclassified components is recaptured under the same all-depreciation-as-ordinary-income logic that applies to Section 1245 property, not the friendlier unrecaptured Section 1250 gain treatment. A cost segregation study that generated large first-year deductions can therefore generate a correspondingly large ordinary income recapture bill down the road, and the allocation of sale proceeds between the building shell and the reclassified components has to be worked out carefully to get the recapture calculation right.
A Note for Corporate Sellers: Section 291
C corporations face an additional wrinkle under Section 291. When a corporation sells Section 1250 property, it must recapture as ordinary income an extra amount equal to 20% of the excess of what the recapture would have been had the property been Section 1245 property, over the actual Section 1250 recapture. In practice, this claws back a slice of the preferential unrecaptured Section 1250 gain treatment specifically for corporate sellers; it does not apply to sales by individuals, partnerships, or S corporations.
Reporting on Form 4797
Both Section 1245 and Section 1250 recapture are figured and reported on Form 4797, Sales of Business Property. Section 1245 recapture is calculated in Part III and carried to Part II as ordinary income. Section 1250 recapture, when there is any, follows the same path; unrecaptured Section 1250 gain is separately computed on the Unrecaptured Section 1250 Gain Worksheet in the Schedule D instructions and flows through to the taxpayer’s capital gain rate calculation.
Key Takeaways
- Section 1245 property (equipment, vehicles, machinery, and similar personal property) recaptures all depreciation taken as ordinary income, up to the amount of gain.
- Section 1250 property (buildings and structural components) only recaptures “additional depreciation,” the excess of accelerated depreciation over straight-line. Real property placed in service after 1986 is normally depreciated straight-line, so this is usually zero.
- Gain attributable to straight-line depreciation on Section 1250 property is still taxed, as unrecaptured Section 1250 gain at a maximum 25% rate, rather than escaping tax entirely.
- Components of a building reclassified as Section 1245 property through a cost segregation study, or Qualified Improvement Property depreciated with bonus depreciation, can trigger full ordinary income recapture on those components even though the overall asset is a building.
- C corporations face an additional Section 291 recapture add-back that does not apply to individuals, partnerships, or S corporations.
- Both types of recapture are reported on Form 4797, with unrecaptured Section 1250 gain computed separately for capital gain rate purposes.
This article is for general informational purposes only and does not constitute tax or legal advice. Depreciation recapture interacts with installment sales, like-kind exchanges of real property, passive activity loss rules, and the allocation of sale price among multiple assets in ways that go beyond what is covered here. Always consult a qualified tax professional before reporting the sale of depreciable business property.
Simplify Your Fixed Asset Depreciation: Figuring recapture correctly starts with knowing exactly how much depreciation, and what kind, was claimed on an asset over its life, and whether it was Section 1245 or Section 1250 property in the first place. Depreciation Calculator Pro II tracks accumulated depreciation by asset and by method on a federal tax, state tax, and book basis, so when it comes time to sell or dispose of an asset, the numbers you need for the recapture calculation are already there instead of buried in years of old schedules.