What Is Section 1250?
Section 1250 of the U.S. Internal Revenue Code requires the IRS to tax gains from the sale of depreciated real property as ordinary income if the accumulated depreciation surpasses what straight-line depreciation would calculate. This rule primarily applies to commercial and residential properties when the accelerated depreciation method is used, affecting investors’ tax obligations significantly.
Key Takeaways
- Section 1250 taxes gains from the sale of depreciated real property as ordinary income if accelerated depreciation exceeds the straight-line method.
- This tax regulation primarily applies to properties depreciated using the accelerated method, which gives larger early deductions.
- Gains treated under Section 1250 are rare due to the current IRS mandate requiring the straight-line method for post-1986 properties.
- If the gain is realized through certain transactions like a gift, death transfer, or like-kind exchange, it is not taxed under Section 1250.
- The taxable gain as ordinary income cannot exceed the actual gain realized from the sale of the property.
Understanding the Tax Implications of Section 1250
Section 1250 deals with taxing gains from selling depreciable real properties like commercial buildings, barns, and rental properties at ordinary tax rates. However, tangible and intangible personal properties and land acreage do not fall under this tax regulation.
Section 1250 applies mainly when a company uses accelerated depreciation, resulting in larger early deductions compared to the straight-line method. Section 1250 states that if a real property sells for a purchase price that produces a taxable gain, and the owner depreciates the property using the accelerated depreciation method, the IRS taxes the difference between the actual depreciation and the straight-line depreciation as ordinary income.
Since the IRS requires straight-line depreciation for all real estate after 1986, treating gains as ordinary income under Section 1250 is rare. If an owner disposes of the property as a gift transferred at death, sells it as part of a like-kind exchange, or disposes of it through other methods, there are no possible taxable gains.
Example: How Section 1250 Affects Taxable Gains
To observe an example of Section 1250 in action, imagine an investor buys an $800,000 real estate property with a 40-year useful life. Five years later, employing the accelerated depreciation method, this investor claims accumulated depreciation expenses in the amount of $120,000, resulting in a cost basis of $680,000.
Let us further assume that this investor unloads the property for $750,000, resulting in a $70,000 total taxable gain. Due to the fact that the accumulated straight-line depreciation amounts to $100,000 (the $800,000 initial price, divided by 40 years, multiplied by five years of use), the Internal Revenue Service must then tax $20,000 of the actual depreciation exceeding straight-line depreciation as ordinary income. The IRS would subsequently tax the $50,000 that remains of the total gain at applicable capital gains tax rates.
Under Section 1250, the recapture of gain as ordinary income is restricted to the actual gain recorded on a real property sale. In our example, if the investor unloaded the real property for $690,000, thereby producing a gain of $10,000, the Internal Revenue Service would only categorize $10,000 as ordinary income, not the additional $20,000.
The Bottom Line
Section 1250 of the U.S. Internal Revenue Code affects how gains from the sale of depreciated real property are taxed. If the accumulated depreciation surpasses what would have been calculated using the straight-line method, those gains get taxed as ordinary income rather than at the capital gains rate. This rule mainly applies when accelerated depreciation methods have been used. While less common today due to IRS rules mandating straight-line depreciation for post-1986 real estate, understanding Section 1250 is crucial for real estate investors who might employ accelerated methods. Investors should be mindful of how depreciation strategies affect potential tax obligations, as these can significantly impact the financial outcomes of property sales.
