Unrecaptured Section 1250 Gain: What Property Investors Need to Know About Depreciation Recapture

When you sell a rental property or commercial building, the IRS doesn’t let you simply pocket the tax breaks you took while owning it. This is where unrecaptured section 1250 gain comes into play—a critical concept that separates savvy real estate investors from those caught off guard by unexpected tax bills.

Understanding Section 1250 and Depreciation Recapture

Section 1250 of the Internal Revenue Code is the tax rule that governs how gains from selling depreciated real property are taxed. The core principle: if you depreciated a building or other business property over the years, that depreciation doesn’t disappear tax-free when you sell. Instead, unrecaptured section 1250 gain forces you to “recapture” those deductions and pay taxes on them at a rate up to 25%—substantially higher than the long-term capital gains rate of 15% or 20%.

The law applies to buildings and structures used for business or investment purposes, but notably excludes land, which cannot be depreciated. Whether you own apartment complexes, office buildings, or retail properties, Section 1250 affects how much tax you’ll owe upon sale.

Why Section 1250 Was Created

Before the 1986 Tax Reform Act, investors could use accelerated depreciation methods to dramatically reduce taxable income quickly. The government eventually clamped down on this loophole. While modern rules now require straight-line depreciation for most properties placed in service after 1986, the recapture provisions remain in force. Any unrecaptured section 1250 gain—the accumulated depreciation claimed during ownership—still faces that higher 25% tax rate at sale.

How Unrecaptured Section 1250 Gain Affects Your Bottom Line

When you sell depreciable real estate, your total gain breaks down into two components. First, there’s the unrecaptured section 1250 gain, which represents the cumulative depreciation deductions you claimed. This portion is taxed at up to 25%. Second, there’s the remaining capital gain—the difference between sale price and adjusted basis minus depreciation—which receives long-term capital gains treatment at 15% or 20%, depending on your income bracket.

Real-world example:

Suppose you purchased a commercial property for $500,000 fifteen years ago. Over that period, you claimed $150,000 in straight-line depreciation deductions. You later sell the property for $700,000.

• Total gain: $350,000 ($700,000 sale price minus $500,000 original cost plus $150,000 depreciation recapture adjustment)
• Unrecaptured section 1250 gain: $150,000 taxed at 25% = $37,500 tax
• Remaining capital gain: $200,000 taxed at 15% or 20% = $30,000 to $40,000 tax
• Total federal tax on sale: $67,500 to $77,500

This example shows why understanding unrecaptured section 1250 gain matters—it can represent 30% to 50% of your total tax liability on a property sale.

Three Strategies to Manage Unrecaptured Section 1250 Gain

1031 Exchange: Deferral Through Reinvestment

A 1031 exchange allows you to defer both capital gains taxes and unrecaptured section 1250 gain recapture by rolling proceeds into a like-kind property. Instead of paying the $67,500+ tax bill immediately, you reinvest and continue growing your portfolio tax-deferred.

The catch: IRS rules are strict. You must identify a replacement property within 45 days and close within 180 days. Miss these deadlines, and the tax deferral evaporates.

Installment Sales: Spread the Tax Over Years

With an installment sale, you receive payments over multiple years rather than a lump sum. This spreads your unrecaptured section 1250 gain and capital gains across multiple tax years, potentially keeping you in a lower tax bracket each year. The trade-off is that you carry seller financing risk and receive less cash upfront.

Cost Segregation Studies: Front-Load Deductions

A cost segregation study reclassifies building components—such as fixtures, equipment, and interior elements—separately from the structural foundation. This accelerates depreciation deductions in early years. While this doesn’t eliminate unrecaptured section 1250 gain recapture later, the higher upfront deductions can offset other income during the ownership period, effectively reducing your long-term tax burden.

Key Takeaway for Property Owners

Understanding unrecaptured section 1250 gain is essential for real estate investment planning. Every dollar of depreciation you deduct today creates future tax liability at the unfavorable 25% rate. Before selling, model your after-tax proceeds using all three strategies. A tax professional can help you determine whether a 1031 exchange, installment approach, or cost segregation study aligns with your investment timeline and financial goals.