Tax Depreciation Concerns in Section 1250

Jan 20, 2024 By Triston Martin

"Tax Geek Tuesday" suggestions are coming up, and some of them might drive away from my few regular readers *cough* interested in tax matters, while others are pure gold. GOLD!! For example, I received an email asking whether I would be willing to spend some time explaining the differences and interactions between Sections 1231, 1245, and 1250, a worthwhile task to be sure. After selling an asset, Section 1001 demands that you subtract from the amount realized the tax basis amount to determine the amount of the resultant gain or loss.


What Is an Unrecognized Gain Under Section 1250?


In the event of a gain on the sale of depreciable property, previously recognized depreciation is reclaimed as income under the Internal Revenue Service's (IRS) section 1250 provision.


As of 2019, unrecaptured section 1250 profits are taxed at a maximum rate of 25 percent or less, depending on the circumstances. 1 Schedule D instructions provide a worksheet for calculating unrecaptured section 1250 profits reported on Schedule D and carried through to the taxpayer's 1040.


How the Unrecaptured Gains of Section 1250 Work



It is important to note that any depreciable capital assets kept for more than one year are included in the definition of Section 1231 assets. Depreciation recapture tax rates are determined by section 1250, which falls under section 1231 and includes assets covered by sections 1245 and 1250. Only structures and land are covered under Section 1250.


Ordinary income depreciation recapture applies to personal property such as machinery and equipment under section 1245. 3 Only when there is a net gain under Section 1231 are unrecaptured section 1250 profits recognized.


Section 1250 states that all depreciable capital losses can offset unrecaptured gains on real estate. Thus, the unrecaptured section 1250 gain is reduced to zero by a net capital loss. Section 1250 gain is regained when depreciated real estate is sold, precisely like any other asset; the only difference is the tax rate.


Unrecorded Gain in Section 1250


Unrecaptured Real property depreciation, whether straight-line or otherwise, is referred to in Section 1250 Gain, except for Section 1250 excess depreciation that must be recouped in ordinary income (see above).


Depreciation is taken on the property but not subject to recapture as regular income is known as unrecaptured Section 1250 Gain. Unrecaptured Section 1250 Gain is taxed at the highest long-term capital gain tax rate of 25 percent (15 percent for taxpayers in the 15 percent and 10 percent tax brackets on ordinary income).


What Happens to Section 1250 Gain In A 1031 Exchange?



The Unrecaptured Section 1250 Gain in a 1031 Exchange has long been a mystery. Is Section 1250 Excess Depreciation postponed in the same way as unrecaptured Section 1250 Gain? Guess what? The Code doesn't address this issue.


Is it only a relic of the past? According to tax experts, the cautious view is to handle how Section 1250 Excess Depreciation is treated (see above). If the replacement property is sold in the future, the Unrecaptured Section 1250 Gain will be liable to the maximum capital gains tax rate of 25 percent.


What If A TaxPayer Must Declare A 1031 Gain Due To Boot?


Using this reasoning, a taxpayer who gets the boot in a 1031 exchange needs to disclose a gain of 25% if they have to record any profit. According to many tax experts, the 25 percent rate gain should be considered before the 15 percent rate gain is applied. This is following Section 453's requirements for reporting an installment sale.


This care of the boot, on the other hand, is not mandated by any authority. When depreciation on the surrendered property is included in the new schedule being transferred to the replacement property and be postponed until the property is sold or otherwise disposed of.


Example of Section 1250 Gains That Were Not Recovered


If a house costs $150,000 and the owner claims $30,000 in depreciation, the property's adjusted cost basis is $120,000. At $185,000, the owner will have made a profit of $65,000 over the property's adjusted cost basis. As a result, any unrecaptured section 1250 profits are based on the difference in value between the modified cost basis and the original purchase price.


Section 1250 taxation is applied to the first $30,000 of profit, while long-term capital gains tax is imposed on the remaining $35,000 of earnings. The higher capital gains tax rate of up to 25 percent would apply to $30,000. The remaining $35,000 would be subject to a tax rate of 15% on long-term capital gains.


Special Considerations


It is necessary to file Form 8949 and Schedule D to record the capital losses, either short-term or long-term. 5 Both the capital loss and gain must be classified as either short-term or long-term to be considered equal. It is impossible to cancel out a long-term benefit with a short-term loss.

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