Understanding Section 1250: The Tax Trap When Selling Investment Real Estate

When you sell a rental property or commercial building that you’ve been depreciating, you might face an unexpected tax bill. This is where Section 1250 and unrecaptured section 1250 gain come into play—a critical concept for any real estate investor planning a property sale.

The Basics of Section 1250 and Depreciation

Section 1250 of the Internal Revenue Code specifically addresses what happens to the gains you make when selling business or investment real estate. The government allows property owners to deduct depreciation annually to offset rental income and account for wear and tear. However, when you eventually sell that property, the IRS wants its share of those tax benefits back.

The key issue is accelerated depreciation. Before 1986, investors could use faster depreciation methods to reduce taxable income more quickly. The tax code created Section 1250 to recapture those extra deductions when properties sold. Today, real estate placed in service after 1986 must use straight-line depreciation—a slower, steadier method—but Section 1250 still applies, and unrecaptured section 1250 gain is taxed at up to 25%.

Which Properties Are Affected?

Section 1250 applies to:

• Commercial office buildings and retail spaces
• Residential rental properties and apartment complexes
• Warehouses and industrial structures
• Any depreciable real property used for business or investment

Land itself is never depreciable and doesn’t trigger Section 1250 recapture. Only the buildings and structures on it are subject to this rule.

Real-World Example: The Math Behind the Tax

Let’s walk through a concrete scenario. An investor purchased a commercial building 15 years ago for $500,000. Over those years, she claimed $150,000 in depreciation deductions on her tax returns. She then sells the building for $700,000.

Here’s how the tax breaks down:

Total gain: $200,000 ($700,000 sale price minus $500,000 cost basis, before accounting for depreciation)

Plus depreciation taken: $150,000 (this gets added back into the gain)

Total taxable gain: $200,000 + $150,000 = $350,000

But not all of this is taxed the same way:

• The $150,000 in depreciation recapture faces taxation at 25%—this represents unrecaptured section 1250 gain
• The remaining $200,000 qualifies for long-term capital gains treatment at 15% or 20%, depending on income level

The difference is significant: paying 25% on $150,000 versus 15% on that same amount means an extra $1,500 in taxes.

Strategies to Reduce Section 1250 Impact

Use a 1031 Exchange

A 1031 exchange lets you reinvest property sale proceeds into another like-kind property while deferring all capital gains taxes, including Section 1250 recapture. This works as long as you follow strict IRS timelines: identify replacement properties within 45 days and close within 180 days. This approach lets you build wealth without triggering immediate tax liability on unrecaptured section 1250 gain.

Spread Gains Over Time With Installment Sales

Rather than receiving payment in full at closing, you can structure the sale so the buyer pays you over several years. This spreads your taxable income and Section 1250 recapture across multiple tax years, potentially keeping you in a lower tax bracket each year and reducing overall tax burden.

Deploy Cost Segregation

A cost segregation study allows you to reclassify certain property components (fixtures, land improvements, equipment) separately from the building structure. This accelerates depreciation deductions in early years. While it doesn’t eliminate Section 1250 recapture later, it generates larger upfront deductions that offset other income during your ownership period.

Why This Matters for Your Portfolio

Understanding Section 1250 and unrecaptured section 1250 gain is essential before selling any investment real estate. The difference between being prepared and being surprised could easily mean tens of thousands of dollars in unexpected taxes.

Before listing a property for sale, consult with a tax professional who understands real estate transactions. They can model different scenarios, estimate your actual tax liability, and recommend strategies tailored to your financial situation. The cost of professional guidance typically pays for itself by minimizing what you owe to the IRS.

Planning ahead transforms this tax obligation from a surprise expense into a manageable part of your investment strategy.