What is {term}? Section 1250

Section 1250 is a section of the U.S. Internal Revenue Code states it will tax a gain from the sale of depreciated real property as ordinary income if 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, and on how many months the filer owned the property.

BREAKING DOWN 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. Personal property, either tangible or intangible, and land do not fall under 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 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 requires owners to depreciate all post-1986 real estate using the straight-line method, treatment of gains as ordinary income under Section 1250 is rare. If an owner disposes of the property 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 — the IRS must tax $20,000 of the actual depreciation that exceeds straight-line depreciation must 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 above example for $690,000, producing a gain of $10,000, the IRS would only consider $10,000 as ordinary income, not the excess $20,000.