What Is Section 1250?
Section 1250 of the U.S. Internal Revenue Code is a rule establishing that the IRS will tax a gain from the sale of depreciated real property as ordinary income if the accumulated depreciation exceeds the depreciation calculated with the straight-line method.
Section 1250 bases the amount of tax due on the type of property, such as residential or nonresidential real estate, while also factoring in how many months the filer owned the property in question.
The Basics of Section 1250
Section 1250 addresses the taxing of gains from the sale of depreciable real property, such as commercial buildings, warehouses, barns, rental properties, and their structural components at an ordinary tax rate. However, tangible and intangible personal properties and land acreage do not fall under this tax regulation.
Section 1250 is chiefly applicable when a company depreciates its real estate using the accelerated depreciation method, resulting in larger deductions in the early life of a real asset, 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.
Because the IRS mandates owners depreciate all post-1986 real estate using the straight-line method, treatment of gains as ordinary income under Section 1250 is a relatively rare occurrence. 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 consequently no possible taxable gains.
Real World 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, which consequently resulted in a cost basis of $680,000.
Now suppose that five years later, the investor sells this property 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), the IRS must tax $20,000 of the actual depreciation that exceeds straight-line depreciation as ordinary income, while taxing the remaining $50,000 of the total gain at applicable capital gains tax rates.
The recapture of gain as ordinary income under Section 1250 is limited to the extent of the actual gain recorded on a sale of real property. If the owner sold the real property in the aforementioned example, for $690,000, thus producing a gain of $10,000, the IRS would consequently only consider $10,000 as ordinary income, and not the excess $20,000.