IRC §§1245 and 1250 — Depreciation Recapture

Plain-English definition

Depreciation recapture is the rule that, on disposition of depreciable property, some or all of the prior-year depreciation deductions are taxed back — at ordinary income rates (§1245) or a special 25% rate (unrecaptured §1250 gain). The IRC §§1245 and 1250 distinction governs which rate applies.

Recapture is calculated on disposition, not as the property is depreciated. It is the timing reversal that makes depreciation a deferral rather than a permanent exclusion.

The §1245 vs §1250 distinction

This is the core concept. The distinction tracks the type of property:

The classification is determined by the property’s MACRS class, which is determined by what the property is — not what the taxpayer wishes to call it. See also the glossary entries for §1245 property and §1250 property.

§1245 mechanics

The §1245 calculation:

1. Adjusted basis = original cost − depreciation taken (including §168(k) bonus and §179 expensing)
2. Recomputed basis = adjusted basis + depreciation taken = original cost
3. §1245 recapture = lesser of (sale price − adjusted basis) or (recomputed basis − adjusted basis) — i.e., the gain up to total depreciation taken, treated as ordinary income
4. Capital gain = sale price − recomputed basis (if positive) — long-term capital gain

A simple example: Equipment purchased for $100,000, fully depreciated (including §179 and bonus) to $0 adjusted basis. Sold for $30,000. Recapture = $30,000 (all gain up to total depreciation). Capital gain = $0.

If sold for $130,000 instead: Recapture = $100,000 (total depreciation taken); Capital gain = $30,000 (excess over original cost).

§1250 mechanics

The §1250 calculation has two parts:

§1250 recapture (ordinary income)

§1250 recapture is the excess of accelerated depreciation over what straight-line would have produced. Under MACRS, real property (27.5-yr residential, 39-yr nonresidential) uses straight-line — so accelerated exceeds straight-line by zero. §1250 ordinary-income recapture is almost always zero for property depreciated under MACRS.

The exception: §168(k) bonus depreciation on the 15-year land improvements portion of a real-property property is §1245 property by reference, not §1250. So while the 27.5-yr or 39-yr structural is §1250 with zero ordinary recapture, the 15-yr land improvements are §1245 with full ordinary recapture.

Unrecaptured §1250 gain (25% rate)

The bulk of depreciation on §1250 real property falls into the unrecaptured §1250 gain bucket under §1(h)(6). This portion of gain is:

• Not §1250 recapture (so not ordinary income under §1250(a))
• Not ordinary income recapture (so the regular long-term capital gain treatment under §1(h) applies)
• But subject to a 25% maximum rate under §1(h)(1)(E) — not the lower 20% long-term capital gains rate

The 25% rate applies to the depreciation taken on the §1250 property up to the realized gain. Gain in excess of cumulative depreciation receives the regular long-term capital gains rate.

Why cost segregation changes the recapture math

A cost-segregated property reclassifies portions of the building basis into 5-year, 7-year, and 15-year property. At sale, these reclassified components are now §1245 property rather than §1250.

The implications:

• 5-yr, 7-yr components: §1245 ordinary-income recapture on the full depreciation taken. The 100% bonus depreciation taken in year 1 is recaptured at up to 37% ordinary rates on disposition.
• 15-yr land improvements: Also §1245 by reference (§1245(a)(3)(D)). Full ordinary recapture.
• Remaining 27.5-yr or 39-yr structural: §1250 with the 25% unrecaptured §1250 gain rate.

The net deferral benefit of cost segregation = the time value of the year-1 deduction at ordinary rates minus the present value of recapture at ordinary rates at sale. For long holds and stable bracket assumptions, the net is positive. For very short holds or rising-bracket assumptions, the net can be negative.

The “trap” pattern

The most common surprise in practice: a taxpayer cost-segregates a property, takes a $250K bonus deduction in year 1 at the 32% bracket (saving $80K), then sells the property three years later at the 37% bracket. The $250K of depreciation is recaptured at 37% ($92,500 owed) — net cost is $12,500 worse than not doing the study.

This is why cost segregation modeling should always include the disposition assumption — bracket at sale, hold period, expected appreciation. A study without this modeling can pencil out to a loss after recapture.

§1031 like-kind exchanges and recapture

A §1031 exchange of real property defers recapture rather than eliminating it. The mechanics:

1. The depreciation taken on the relinquished property does not trigger recapture at the time of exchange.
2. The replacement property’s basis is reduced by the relinquished property’s adjusted basis (carryover basis).
3. The depreciation taken on the relinquished property becomes part of the replacement property’s depreciation history.
4. When the replacement is eventually sold without further exchange, the cumulative depreciation from both properties is recaptured.

§1031 is now limited to real property only (TCJA §13303). Personal property exchanges (equipment, FF&E) are taxable events with §1245 recapture at the time of exchange.

Installment sales and recapture

Under §453(i), §1245 recapture must be reported as ordinary income in the year of sale, even on an installment-sale disposition. Only the gain in excess of recapture is eligible for installment treatment.

Practical effect: a cost-segregated property sold on an installment note triggers all the §1245 recapture in year 1, while the §1250 (real property) gain can be spread across installments.

Common errors

1. Assuming all real-property gain gets 20% long-term capital gains. The unrecaptured §1250 gain is at the 25% maximum, not 20%. Models that use 20% understate the tax on disposition.

2. Forgetting the 15-yr land improvements are §1245. Parking lots, sidewalks, site lighting — all 15-yr property — are §1245 property by reference under §1245(a)(3)(D). The 100% bonus depreciation taken on these gets full ordinary recapture, not §1250 treatment.

3. §179 on lodging-type property and recapture if business use drops. §179 deductions are recaptured under §1245 if business use of the property drops to 50% or less during the recovery period.

4. Installment sale of cost-segregated property without recapture-first reporting. Failing to report §1245 recapture in year 1 of an installment sale is a common audit-flag error.

5. Treating §1031 boot as escape from recapture. When a §1031 exchange includes boot (cash or non-like-kind property received), recapture is triggered on the boot first under §1245(b)(4). The shelter only applies to the non-boot portion.

Sources

• Statute: 26 U.S.C. § 1245 — Cornell LII; 26 U.S.C. § 1250 — Cornell LII
• Regulations: Treas. Reg. § 1.1250-1, § 1.1245-1
• Section 1(h): 26 U.S.C. § 1(h)(1)(E) and § 1(h)(6) — the 25% unrecaptured §1250 gain rate
• Publications: Pub. 946 — How to Depreciate Property; Pub. 544 — Sales and Other Dispositions of Assets
• Forms: Form 4797 — Sales of Business Property

Modeling recapture on a specific property? The §1245 vs §1250 split, combined with hold period and bracket assumptions at sale, determines whether a cost segregation study nets positive or negative. A decision tool that accounts for recapture in the cost-seg ROI shows the per-property break-even hold period.