Section 1250 of the United States Internal Revenue Code dictates that the IRS will tax gains from the sale of depreciated real property as ordinary income if the accumulated depreciation surpasses what would have been computed using the straight-line method.
Section 1250’s tax criteria vary based on the nature of the property—be it residential or nonresidential real estate—and depend on how long the filer has owned the property.
Key Takeaways
- Section 1250 of the U.S. Internal Revenue Code stipulates that any gain from selling depreciated real property will be taxed as ordinary income if the accumulated depreciation exceeds straight-line depreciation.
- This section is primarily relevant for businesses that use the accelerated depreciation method when depreciating their real estate assets.
Unlocking the Basics of Section 1250
Section 1250 concerns the taxation of gains from selling depreciable real property, such as commercial buildings, warehouses, barns, rental properties, and their structural components, at ordinary income rates. Land and tangible and intangible personal properties do not fall under this provision.
This section is particularly applicable when a company uses the accelerated depreciation method, resulting in greater deductions early in the asset’s life compared to the straight-line method. According to Section 1250, if a property’s sale generates a gain and it was depreciated using the accelerated method, the IRS taxes the difference between actual depreciation and straight-line depreciation as ordinary income.
Given that the IRS requires straight-line depreciation for all post-1986 real properties, gains treated as ordinary income under Section 1250 are relatively scarce. Furthermore, gains become nontaxable if the property is gifted, transferred at death, or disposed of through a like-kind exchange.
A Real-World Example of Section 1250
Let’s look at a practical example to understand Section 1250’s implications. Suppose an investor purchases an $800,000 property with a 40-year useful life. After five years, using the accelerated depreciation method, the investor claims $120,000 in accumulated depreciation, reducing the property’s cost basis to $680,000.
If the investor sells the property for $750,000, this would create a $70,000 taxable gain. Given that straight-line depreciation over this period amounts to $100,000 ($800,000 divided by 40 years, multiplied by 5 years), the IRS would tax the $20,000 of extra depreciation—over the straight-line amount—as ordinary income. The remaining $50,000 gain would be taxed at applicable capital gains rates.
Under Section 1250, the recapture of gain as ordinary income is capped by the actual gain from the sale. If the sale proceeds were $690,000, generating a $10,000 gain, the IRS would only qualify $10,000 as ordinary income and not the additional $20,000.
Related Terms: Accelerated Depreciation, Straight-Line Depreciation, Real Estate Investment, Ordinary Income, Capital Gains Tax.
References
- Internal Revenue Service. “Publication 544”, Page 43.
