What Is an Unrecaptured Section 1250 Gain?

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DEFINITION

An unrecaptured Section 1250 gain is the gain you earn after selling a Section 1231 asset for which you claimed depreciation tax in previous years.

Definition and Example of an Unrecaptured Section 1250 Gain

Section 1250 of the Internal Revenue Code (IRC) kicks in when you sell a Section 1231 real estate asset for financial gain after claiming a depreciation tax break for it in previous years. The IRS says the gain is taxable at a pretty significant rate—higher than those for most long-term capital gains.

Section 1231 property is typically business or trade real estate, so unrecaptured Section 1250 gains usually only come into play for non-business owners if they have rental property.

A capital asset becomes an IRC Section 1231 asset if it’s depreciable and you own it for more than one year before you sell or otherwise dispose of it.

Let’s say you purchased a rental property for $200,000 in 2020. You’re entitled to depreciate it over five years. That works out to $40,000 per year: $200,000 divided by five. You claim $80,000 in depreciation in 2020 and 2021. This brings your cost basis down to $120,000 ($200,000 minus $80,000) in claimed depreciation.

You sell the property for $250,000 in 2022. Under Section 1250 rules, you’ve realized a gain of $130,000 ($250,000 minus your $120,000 basis adjusted for depreciation), not $50,000 ($250,000 minus your $200,000 purchase price). The $80,000 you claimed as depreciation is recaptured and taxed at a maximum of 25%. Only the remaining $50,000 is taxed at the more favorable long-term capital gains tax rate of just 15%.

How an Unrecaptured Section 1250 Gain Works

Section 1250 tags the gain you get from selling property as “unrecaptured” when the sales price exceeds your initial cost basis in the asset, which is the total of what you paid for it and spent on maintaining it. It adjusts this basis by adding back the depreciation you claimed.

An unrecaptured Section 1250 gain effectively prevents you from taking a double-dip tax break. It changes the rate at which realized gains are taxed with the intention of offsetting that depreciation you claimed. It prohibits you from claiming advantageous long-term capital gains rates on the entirety of your profit.

But “offset” is the key word here in another respect. The IRC allows you to offset Section 1250 gains with Section 1231 capital losses, provided both assets were held for more than a year so both your loss and your gain are long term. This means you can subtract your loss from the amount of your gain, and pay tax on the difference.

A capital loss occurs when you sell an asset for less than your initial cost basis. This would be the case if you sold a $200,000 property for $175,000. You’d have a $25,000 loss, assuming you claimed no depreciation so you didn’t have to add it back in and adjust your cost basis.

How To Report Uncaptured Section 1250 Gains

You report uncaptured Section 1250 gains on Form 4797, then transfer that total to Schedule D. The instructions for Schedule D include detailed explanations and worksheets to help you make your calculations. Enter the resulting tax amount on line 16 of your Form 1040 tax return.

How Much Are Taxes on Unrecaptured Section 1250 Gains?

The tax on unrecaptured Section 1250 gains tops out at 25%, which is considerably higher than two of the three tax rates for long-term capital gains, which ranges from 0% to 20%, depending on your income. Most taxpayers pay a 0% or 15% rate on long-term capital gains, which is at least 10% less than the unrecaptured Section 1250 rate.

The 25% rate applies to money received in the first through fourth years if you accepted installment payments after 1999. Some gains can be taxed at 20% after the first four years, but this is still higher than the long-term capital gains tax rate for most taxpayers.

Key Takeaways

  • A higher unrecaptured Section 1250 tax rate applies to long-term capital gains for which a taxpayer has previously claimed depreciation.
  • The IRC requires that claimed depreciation must be factored back in to arrive at an adjusted cost basis for calculating the amount of a capital gain.
  • The Section 1250 rate is usually 20%, compared to the 15% long-term capital gains rate that applies for most taxpayers when the asset hasn’t been depreciated for tax purposes.
  • A Section 1250 adjusted cost basis can be offset by capital losses.

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Article Sources

  1. Cornell Law School Legal Information Institute. “26 U.S. Code § 1231—Property Used in the Trade or Business and Involuntary Conversions.”

  2. IRS. “Topic No. 409 Capital Gains and Losses.”

  3. PicnicTax. “What Is Section 1231 Gain? Real Estate Sale Tax Advantages.”

  4. IRS. “2021 Instructions for Schedule D,” Pages D14-D15.

  5. Code of Federal Regulations. “Title 26.