What Is Section 1250?
Let me explain Section 1250 of the U.S. Internal Revenue Code directly: it requires the IRS to tax gains from the sale of depreciated real property as ordinary income if the accumulated depreciation exceeds what straight-line depreciation would have calculated. You need to know this primarily affects commercial and residential properties where accelerated depreciation was used, and it can significantly impact your tax obligations as an investor.
Key Takeaways
- Section 1250 taxes gains from depreciated real property sales as ordinary income if accelerated depreciation exceeds the straight-line method.
- This applies mainly to properties depreciated with accelerated methods, which provide larger early deductions.
- Such gains are rare today because the IRS mandates straight-line depreciation for properties after 1986.
- No taxation under Section 1250 occurs for gains from gifts, transfers at death, or like-kind exchanges.
- The taxable ordinary income can't exceed the actual gain from the sale.
Understanding the Tax Implications of Section 1250
As a real estate investor, you should understand that Section 1250 deals with taxing gains from selling depreciable real properties—think commercial buildings, barns, or rental units—at ordinary tax rates. Keep in mind, this doesn't cover tangible or intangible personal property or land itself.
This section kicks in when you've used accelerated depreciation, which gives you bigger deductions early on compared to straight-line. If you sell the property for a gain and you've depreciated it accelerated, the IRS will tax the difference between your actual depreciation and what straight-line would have been as ordinary income.
Since the IRS now requires straight-line for all real estate after 1986, Section 1250 ordinary income treatment is uncommon. Also, if you dispose of the property via gift, transfer at death, like-kind exchange, or similar, there are no taxable gains under this rule.
Example: How Section 1250 Affects Taxable Gains
To see Section 1250 in action, consider this scenario: suppose you buy a real estate property for $800,000 with a 40-year useful life. After five years, using accelerated depreciation, you've claimed $120,000 in depreciation, dropping your cost basis to $680,000.
Now, if you sell it for $750,000, that's a $70,000 total gain. The straight-line depreciation over five years would be $100,000 ($800,000 divided by 40, times five). So, the IRS taxes the $20,000 excess depreciation as ordinary income, and the remaining $50,000 at capital gains rates.
Remember, under Section 1250, the ordinary income recapture is capped at the actual gain. If you sold for $690,000 instead, yielding a $10,000 gain, only $10,000 would be ordinary income—not the full $20,000 excess.
The Bottom Line
In essence, Section 1250 affects how gains from depreciated real property sales are taxed: if your depreciation exceeds straight-line, that excess is ordinary income, not capital gains. This mainly applies to accelerated methods, which are less common post-1986 due to IRS rules. As an investor, you must grasp this to manage your depreciation strategies and anticipate tax impacts on sales— it can make a big difference in your financial results.
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