A real estate investor researching how Section 1250 applies to real estate taxes.
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Section 1250 of the U.S. tax code applies to gains from the sale of depreciated business real estate. If a property was depreciated beyond the straight-line method, the extra depreciation is taxed at a higher rate, known as depreciation recapture. Because real estate taxes can be complex, a financial advisor can help investors plan tax-efficient property sales.
Section 1250 of the Internal Revenue Code governs the taxation of gains derived from the sale of depreciable real property used in business or investment activities. It applies specifically to real estate improvements, including buildings and structures, but not to land, which is a non-depreciable asset.
When an investor buys a building for business or rental use, the IRS allows depreciation deductions over time to account for the property’s gradual wear and tear. If the property is later sold, the investor may owe depreciation recapture tax on the portion of the gain that results from depreciation deductions. This means that any gain attributable to depreciation exceeding what would have been allowed under the straight-line depreciation method is recaptured and taxed at a higher rate.
Depreciation recapture happens when an investor uses accelerated depreciation instead of the straight-line method. Before the 1986 Tax Reform Act, investors could accelerate depreciation to lower taxable income faster. Section 1250 was created to limit excessive tax benefits by taxing extra depreciation deductions when the property was sold.
For properties placed in service after 1986, only straight-line depreciation is allowed, making Section 1250 recapture less common today. However, any gains from depreciation are still taxed at a higher rate of up to 25%, instead of the lower long-term capital gains rate.
A taxpayer reviews an example of Section 1250 depreciation recapture.
Section 1250 applies to commercial and residential rental properties, office buildings and other depreciable real estate assets that have been depreciated over time. When a property owner sells one of these assets, any gain associated with previously claimed depreciation deductions is subject to recapture at a tax rate of up to 25% instead of the standard capital gains tax rate.
Let’s assume that an investor bought a commercial property 15 years ago for $500,000 and depreciated $150,000 of its value over that time using the straight-line method. The investor then sells the property for $700,000, resulting in a total gain of $350,000 ($700,000 – $500,000 + $150,000 depreciation taken).
Depreciation recapture: The $150,000 in depreciation is recaptured and taxed at up to 25%.
Remaining capital gain: The remaining $200,000 gain is taxed at the standard long-term capital gains rate, which can be 15% or 20%, depending on the investor’s income bracket.
Reducing the impact of Section 1250 depreciation recapture requires strategic tax planning when selling or transferring real estate. Here are three common strategies to consider.
A 1031 exchange allows real estate investors to defer capital gains taxes, including Section 1250 recapture, by reinvesting the proceeds of a property sale into a like-kind property. This tax-deferred exchange enables investors to continue growing their portfolio without immediate tax consequences. However, strict IRS rules apply, including identification and reinvestment deadlines.
An installment sale allows a seller to spread out capital gains and depreciation recapture taxes over multiple years by receiving payments over time rather than in a lump sum. This approach can reduce the seller’s overall tax burden by keeping annual income lower.
A cost segregation study can help investors accelerate depreciation deductions by classifying certain building components separately from the structure itself. While this does not eliminate Section 1250 recapture, it allows for higher upfront deductions that may offset other taxable income. Investors should work with a tax consultant to assess whether a cost segregation strategy aligns with their financial goals.
A woman reviews documents for her real estate portfolio.
Section 1250 affects real estate investors and property owners who have claimed depreciation on their assets. It determines how depreciation recapture is taxed when a property is sold, balancing previous tax benefits. Investors looking to sell depreciated property should understand these tax implications and explore strategies like 1031 exchanges, installment sales, or cost segregation studies to reduce their tax liability.
A financial advisor can help you create a tax plan to manage your liability. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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