Section 1245 and 1250 Depreciation Recapture: CPA REG Guide

Understanding Depreciation Recapture Under IRC Sections 1245 and 1250

When a taxpayer sells depreciable property at a gain, the IRS requires that some or all of the gain attributable to prior depreciation deductions be "recaptured" as ordinary income rather than receiving favorable capital gain treatment. This mechanism prevents taxpayers from converting ordinary deductions into capital gains. Two primary Code sections govern recapture: Section 1245 for personal property and Section 1250 for real property.

For CPA candidates, depreciation recapture is one of the most frequently tested areas on the REG section. The rules interact with Section 1231 (discussed separately) and require precise understanding of how gains are characterized and taxed.

Section 1245 Recapture: Personal Property

Scope and Application

Section 1245 applies to depreciable personal property such as machinery, equipment, vehicles, furniture, and certain other tangible and intangible assets. It also applies to certain real property, including single-purpose agricultural and horticultural structures, storage facilities for petroleum products, and railroad grading and tunnel bores.

Under Section 1245, the entire amount of gain attributable to depreciation is recaptured as ordinary income. This is sometimes called "full recapture." The recapture amount is the lesser of the recognized gain or the total depreciation (or amortization) taken on the property. Only gain in excess of total depreciation is treated as Section 1231 gain, which may qualify for long-term capital gain rates.

Calculation Example

Suppose a taxpayer purchased equipment for $100,000 and claimed $60,000 in depreciation, resulting in an adjusted basis of $40,000. If the equipment is sold for $85,000, the recognized gain is $45,000. Under Section 1245, the entire $45,000 is ordinary income because it does not exceed the $60,000 of depreciation taken. If the equipment were sold for $110,000, the gain would be $70,000. Of that, $60,000 (the depreciation taken) would be ordinary income under Section 1245, and the remaining $10,000 would be Section 1231 gain.

Section 1250 Recapture: Real Property

Current Application

Section 1250 applies to depreciable real property, primarily buildings and structural components. Under current law, since the Tax Reform Act of 1986 generally requires straight-line depreciation for real property, Section 1250 recapture as ordinary income is limited. Section 1250 recaptures only the excess of accelerated depreciation over what straight-line depreciation would have been. Because real property placed in service after 1986 uses straight-line depreciation, there is typically no Section 1250 ordinary income recapture for such property.

Unrecaptured Section 1250 Gain

Even though Section 1250 ordinary recapture rarely applies, the tax law imposes a special 25% maximum rate on "unrecaptured Section 1250 gain." This is the portion of long-term capital gain on Section 1250 property attributable to straight-line depreciation. This gain is taxed at a maximum rate of 25%, which is higher than the standard 15% or 20% long-term capital gain rate but lower than ordinary income rates.

For example, if a building was purchased for $500,000 and $100,000 in straight-line depreciation was taken, and the building sells for $550,000, the total gain is $150,000. Of that, $100,000 is unrecaptured Section 1250 gain taxed at up to 25%, and the remaining $50,000 is Section 1231 gain eligible for the regular long-term capital gain rate.

Exceptions to Recapture

Gifts: No recapture occurs on a gift. The recapture potential carries over to the donee.
Death: Recapture potential is eliminated at death because the heir receives a stepped-up basis.
Like-kind exchanges (Section 1031): Recapture is deferred to the extent gain is not recognized. Boot received may trigger recapture.
Involuntary conversions (Section 1033): Similar deferral rules apply when proceeds are reinvested in qualified replacement property.
Charitable contributions: Generally no recapture, but the charitable deduction may be reduced.

CPA Exam Strategies

Always determine whether property is Section 1245 (personal) or Section 1250 (real) property first.
For Section 1245 property, recapture the lesser of gain or total depreciation as ordinary income.
For Section 1250 property placed in service after 1986, expect unrecaptured Section 1250 gain at 25% rather than ordinary income recapture.
Remember the ordering: recapture rules apply before Section 1231 netting.
Watch for exceptions, especially like-kind exchanges and transfers at death.