Section 1250

What is 'Section 1250'

Section 1250 is a section of the United States Internal Revenue Service Code that states that a gain from selling real property that has been depreciated should be taxed as ordinary income, to the extent that the accumulated depreciation exceeds the depreciation calculated using the straight-line method. Section 1250 bases the amount of tax due on the type of property, such as residential or nonresidential property, and on how many months the property was owned.

BREAKING DOWN 'Section 1250'

Section 1250 deals with taxing gains at an ordinary tax rate that arises from selling depreciable real property, such as commercial buildings, warehouses, barns, rental properties and their structural components. Personal property, either tangible or intangible, and land do not fall under the scope of this tax regulation. Section 1250 is mainly applicable when a company depreciates its real estate using the accelerated depreciation method, which results in larger deductions in the early life of a real asset, in comparison to the straight-line method. Section 1250 says that if a real property sells for a purchase price that produces a taxable gain, and that property is depreciated using the accelerated depreciation method, the difference between the actual depreciation and the straight-line depreciation is taxed as ordinary income.

Because all post-1986 real estate is required to be depreciated using the straight-line method, treatment of gains as ordinary income under Section 1250 is rare. If the property is disposed of as a gift, transferred at death, sold as part of a like-kind exchange, or disposed of through other methods, no possible taxable gain exists.

An Example of Section 1250 Applicability

Consider an investor who purchased real estate with a useful life of 40 years for a total purchase price of $800,000. After five years, the investor claimed $120,000 in accumulated depreciation expenses using the accelerated depreciation method, resulting in a cost basis of $680,000. Suppose that the investor sells this property after five years for $750,000, for a total taxable gain of $70,000. Because the accumulated straight-line depreciation is $100,000 (initial price of $800,000 divided by 40 years times five years of use), $20,000 of the actual depreciation that exceeds straight-line depreciation must be taxed as ordinary income, while the remaining $50,000 of the total gain is taxed at applicable capital gains tax rates.

The recapture of gain as ordinary income under Section 1250 is limited to the extent of actual gain recorded on a sale of real property. If the real property in the above example was sold for $690,000, producing a gain of $10,000, only $10,000 would be considered ordinary income, not the excess $20,000.