What Is Section 1250?

Section 1250 of the United States 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 property type—on whether it is residential or nonresidential real estate—while also factoring in how many months the filer owned the property in question.

Key Takeaways

  • Section 1250 of the U.S. Internal Revenue Code establishes 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 is chiefly applicable when a company depreciates its real estate using the accelerated depreciation method.

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 to depreciate all post-1986 real estate using the straight-line method, the 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 no possible taxable gains.

An Example of an Application of Section 1250

To observe a real-world 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.