Understanding IRS Section 1245: What Real Estate Investors Really Need to Know

When you sell a depreciated property, here’s what actually happens with your taxes—and why IRS Section 1245 matters more than you think. This tax code provision specifically addresses depreciation recapture, a mechanism that can turn your “favorable” capital gains into ordinary income. For real estate investors juggling multiple property types, this distinction between how gains get taxed can mean the difference between a solid profit and an unexpected tax hit.

The Core Problem: Depreciation Recapture Under IRS Section 1245

Let’s break down what’s really going on. You bought equipment or a rental property, claimed depreciation deductions year after year (reducing your taxable income), and now you’re selling at a profit. Here’s where IRS Section 1245 kicks in: the tax code requires you to “recapture” that depreciation benefit by taxing the gain as ordinary income rather than at the more favorable capital gains rate.

Think of it this way—if you sell an asset for more than its depreciated value, the IRS looks at two different gains:

The depreciation portion: Any gain up to the amount of depreciation you previously claimed gets taxed as ordinary income. This is the recapture piece.

The appreciation portion: Any gain exceeding your original cost may qualify for capital gains treatment, which typically means a lower tax rate.

This split-taxation approach fundamentally changes how much you actually keep from a property sale, especially if you’ve claimed substantial depreciation over many years.

Which Properties Actually Fall Under Section 1245?

Not all real estate is treated the same way. IRS Section 1245 primarily covers personal property and specific depreciable assets used in business contexts. Equipment essential to manufacturing, production, or extraction processes typically qualifies. Rental property furniture, fixtures, and vehicles used in the business also fall under this umbrella.

Here’s what’s important: residential buildings themselves—like single-family homes owned as rental investments—usually aren’t subject to Section 1245 recapture rules (they fall under different depreciation recapture provisions instead). But the improvements within those buildings? Elevators, escalators, or other depreciable components might be covered, depending on how they’re classified and depreciated.

The distinction matters because misclassifying an asset can lead to unexpected tax consequences.

Calculating Your Actual Tax Liability on a 1245 Property

The math isn’t complicated, but precision matters. Start with the adjusted cost basis—your original purchase price minus all the depreciation you claimed over time. When you sell, calculate the gain by subtracting this adjusted basis from your sale price.

Here’s the critical part: examine how much of that gain comes from depreciation recapture versus appreciation. The recapture portion (up to the total depreciation claimed) gets ordinary income treatment. The remainder potentially qualifies for capital gains rates.

For example: You purchased equipment for $100,000, claimed $40,000 in depreciation (bringing adjusted basis to $60,000), and sold it for $110,000. Your total gain is $50,000. Of that, $40,000 gets taxed as ordinary income (the recapture), and only $10,000might qualify for capital gains treatment. That’s a significant tax rate difference.

Why This Matters for Your Real Estate Strategy

Understanding IRS Section 1245 isn’t just tax compliance—it’s financial planning. When you’re evaluating whether to sell a depreciated property, factor in the recapture tax liability. A property that looks profitable on paper might have a much smaller net gain after you account for ordinary income tax rates on the recaptured depreciation.

Strategic timing matters too. If you’re managing a portfolio with different asset types and holding periods, the tax implications of each sale can substantially impact your overall return. Some investors deliberately sequence property sales across years to manage their tax brackets and recapture obligations.

The bottom line: real estate investors who grasp how IRS Section 1245 works can anticipate their actual tax liability, optimize sale timing, and make genuinely informed decisions about which properties to hold and which to sell. Without this knowledge, you might be caught off-guard by a significantly higher tax bill than you expected.