Section 1250: Tax Implications for Real Estate Investors

Section 1250 of the U.S. Internal Revenue Code is a critical rule that every real estate investor needs to understand. It determines how you’ll be taxed when selling depreciated commercial or residential properties, potentially affecting your bottom line significantly.

Understanding Section 1250 and Depreciation Recapture

When you purchase income-producing real estate, the IRS permits you to deduct depreciation annually—a paper loss that reflects the property’s wear and tear. Buildings and structures qualify for these deductions, though land itself does not since it’s considered non-depreciable.

However, when you eventually sell that property, Section 1250 comes into play. The depreciation you claimed on your tax returns gets “recaptured” and taxed at a higher rate—up to 25%—rather than the standard long-term capital gains rate of 15% or 20%. This represents the government’s way of clawing back some of the tax benefits you received from depreciation deductions over the years.

The Role of Accelerated vs. Straight-Line Depreciation

Historically, investors used accelerated depreciation methods to write off property value more quickly, reducing taxable income faster. Section 1250 was designed specifically to prevent excessive tax avoidance through this strategy. For real estate placed in service after 1986, only straight-line depreciation is permitted, making aggressive recapture less common today. Still, any gain attributable to depreciation deductions faces that higher 25% tax rate.

Practical Example: How Section 1250 Recapture Works

Consider this scenario: You purchased a commercial building for $500,000 fifteen years ago. Using straight-line depreciation, you deducted $150,000 over those years. Today, you sell the property for $700,000.

Your taxable gain totals $350,000 ($700,000 sale price minus $500,000 purchase price, plus the $150,000 you depreciated). Here’s how the tax splits:

• Recaptured depreciation: The $150,000 gets taxed at the 25% Section 1250 rate, costing you $37,500 in federal taxes
• Remaining gain: The $200,000 difference is treated as a long-term capital gain, taxed at either 15% or 20% depending on your tax bracket, costing between $30,000–$40,000

Without strategic planning, your effective tax rate could exceed 30% on this transaction.

Smart Strategies to Reduce Section 1250 Tax Impact

Three primary approaches help investors minimize depreciation recapture taxes:

1031 Exchange Strategy

A 1031 exchange permits you to reinvest property sale proceeds into a like-kind replacement property, deferring all capital gains and depreciation recapture taxes indefinitely. The catch: strict IRS timelines apply. You must identify replacement properties within 45 days and complete the exchange within 180 days. This approach is ideal for investors planning long-term portfolio growth.

Installment Sale Approach

Rather than receiving all proceeds upfront, you can structure the sale to receive payments over several years. This spreads your taxable gains—including Section 1250 recapture—across multiple tax years, potentially keeping you in a lower tax bracket and reducing your total tax liability.

Cost Segregation Studies

This strategy classifies building components separately (mechanical systems, fixtures, etc.) to accelerate depreciation deductions in early years. While it doesn’t eliminate Section 1250 recapture later, higher upfront deductions can offset other income during ownership, improving your overall tax position.

Key Takeaway for Property Sellers

Section 1250 recapture is an inevitable cost of real estate investing—but it’s not unavoidable through proper planning. Before selling any depreciated property, evaluate whether a 1031 exchange, installment sale, or cost segregation strategy aligns with your financial objectives. Working through these options with a tax professional can help you structure the transaction to preserve more of your gains and keep your tax liability manageable.