Unrecaptured Section 1250 Gain in Plain Terms

When you sell depreciated real estate, part of your gain is attributable to depreciation you took on the building. The tax code has a special category for that part. It is called unrecaptured Section 1250 gain, and it is subject to a maximum rate that is higher than the long-term capital gain rate for many taxpayers but generally lower than top ordinary rates. The figure is set by law and may change.

Where the category comes from

Long-term capital gains have preferential rates. Congress carved out gain attributable to depreciation on real property so that it is taxed at a higher maximum rate. The category applies to real property such as buildings that has been held long term. It is not tied to whether you had a cost segregation study.

How it is computed, in general terms

Take the gain on the sale of real property. Then, up to the amount of straight line depreciation previously allowed on that property, the gain is treated as unrecaptured Section 1250 gain. The remainder of the gain, generally the appreciation above original cost, is taxed at regular long-term capital gain rates. Losses and other items are netted in a specific order, so the computation belongs to your preparer.

A hypothetical

Suppose a building was bought for $500,000, depreciation of $80,000 was taken, and it is sold for $600,000. Adjusted basis is $420,000. The gain is $180,000. Of that, $80,000 might be unrecaptured Section 1250 gain, and $100,000 might be capital gain from appreciation. This is a hypothetical to show the pieces, not a tax computation. See Hypothetical: Sale and Recapture After a Study.

The effect of a study

A study does not change the total depreciation over the life of the property, but it changes where the depreciation lands. Depreciation on personal property is recaptured as ordinary income to the extent of gain. Depreciation on land improvements may involve excess over straight line as ordinary income. Depreciation on the building portion is the unrecaptured Section 1250 gain. See Depreciation Recapture on Sale: What Comes Back.

Why the distinction matters in planning

If you claim more depreciation sooner, a larger portion of your eventual gain may be categorized as depreciation-related. Compare the tax at each category's rate with the tax at ordinary rates you avoided by deducting earlier.

Interaction with other taxes

The net investment income tax may apply to gain, depending on your circumstances. State taxes vary. See Net Investment Income Tax and Depreciation.

Installment sales

If you sell using an installment method, unrecaptured Section 1250 gain is generally recognized first as payments are received, and ordinary recapture is generally recognized in the year of sale. Discuss with your preparer.

Exchanges

A qualifying like-kind exchange can defer gain, including this category. See Section 1031 Exchanges and Depreciation Recapture.

Death and basis rules

Basis at death is governed by rules that may change. Do not plan around assumptions. Ask an estate professional. See Hold Period and the Decision.

Common misunderstandings

• "Recapture applies only if I did a study." No, depreciation on real property creates this category regardless.
• "Capital gains rates apply to all gain." Not all of it.
• "I can avoid recapture by not claiming depreciation." Depreciation allowable reduces basis regardless.

Why this category exists

The tax code gives preferential rates to long-term capital gains. To avoid letting all the gain attributable to real property depreciation enjoy the lowest rates, the law carves out a portion and applies a higher maximum rate. Because real property depreciation had been deducted at ordinary rates over the years, taxing it at a somewhat higher capital gain rate on sale is seen as a partial reversal.

Interaction with losses and netting

Long-term capital gains and losses are netted in a specified order, and different rate groups are computed in sequence. A capital loss from another asset may reduce gain in the highest rate groups first, under the ordering rules. Your preparer's software handles this, but it is worth asking for a summary of the components so that you understand what is happening.

Effect of a study on the composition of gain

A study changes the composition. More of your depreciation is on personal property and land improvements. Personal property depreciation produces ordinary recapture rather than unrecaptured Section 1250 gain, at least to the extent of gain. So a study may shift some of the gain from the unrecaptured Section 1250 category into ordinary recapture, which could be taxed at a higher rate than the special maximum rate. This is a subtle point that is easy to miss when comparing after-tax outcomes.

Estimating for planning

To estimate, add the depreciation you expect to take on real property to your projected gain, apply the assumed maximum rate, and compare with the tax at ordinary rates on the depreciation you deducted earlier. Using assumed rates that you verify with your preparer, you can see the direction. Keep the estimate flexible.

Next steps

Read Section 1031 Exchanges and Depreciation Recapture for deferral and Hold Period and the Decision for planning.