Understanding 1245 and 1250 Depreciation Recapture and How They Are Taxed in Business Transactions

When selling business assets, one of the key considerations for both sellers and buyers is depreciation recapture. Depreciation recapture refers to the process of taxing the gain on the sale of certain assets that have been depreciated. The Internal Revenue Code (IRC) Sections 1245 and 1250 specifically deal with the recapture of depreciation on personal property and real property, respectively. Understanding how these sections work is critical for business owners and investors to properly account for taxes in a business transaction.

What is Depreciation Recapture?

Depreciation recapture occurs when a business sells an asset that has been depreciated over time. Depreciation allows businesses to deduct the cost of an asset over its useful life, reducing taxable income during that period. However, when the asset is sold for more than its depreciated value, the IRS requires businesses to "recapture" the depreciation taken and pay taxes on that amount. This recaptured depreciation is taxed as ordinary income, up to certain limits, instead of the lower capital gains rate.

Section 1245: Depreciation Recapture on Personal Property

Section 1245 applies to assets that are considered "personal property" or "depreciable property," such as machinery, equipment, and vehicles. If these assets have been depreciated using a method such as straight-line or accelerated depreciation, the gain from the sale of the asset is subject to depreciation recapture.

How It Works:

• If a business sells an asset covered under Section 1245, the depreciation recapture is taxed as ordinary income, up to the amount of depreciation previously claimed.

• The recapture amount is limited to the depreciation that has been deducted or amortized over the life of the asset. Any gain in excess of the depreciation recapture amount will be taxed as a capital gain.

• For example, if a piece of machinery was bought for $100,000 and depreciated by $40,000 over its useful life, the first $40,000 of gain from the sale of that machinery would be taxed as ordinary income due to depreciation recapture, and the remaining gain would be taxed at the capital gains rate.

Tax Rate:

• The amount subject to recapture under Section 1245 is taxed at ordinary income tax rates, which can be as high as 37% (as of 2025). This is significantly higher than the long-term capital gains rate, which ranges from 0% to 20%, depending on income levels.

Section 1250: Depreciation Recapture on Real Property

Section 1250 applies to real property, such as buildings and other structures, which has been depreciated. Unlike Section 1245, which applies to personal property, Section 1250 has more limited recapture provisions and primarily affects commercial real estate transactions.

How It Works:

• When a property owner sells depreciated real property, the gain attributable to the depreciation taken on the property is subject to recapture. However, the recapture under Section 1250 does not apply to the entire gain but only to the portion of the gain related to depreciation deductions taken under the Modified Accelerated Cost Recovery System (MACRS).

• For real property, only "excess depreciation" — depreciation that exceeds straight-line depreciation — is subject to recapture under Section 1250.

Tax Rate:

• The recaptured depreciation under Section 1250 is taxed at a maximum rate of 25%, which is lower than the ordinary income tax rate but higher than the capital gains rate.

• If the property has been depreciated under straight-line depreciation (which is common for real estate), there may be little to no recapture, and the gain may be treated as a long-term capital gain.

Impact of Depreciation Recapture in Business Transactions

Depreciation recapture can significantly impact the net proceeds from the sale of a business or business assets. Buyers and sellers need to factor this tax consideration into their negotiations and overall transaction strategy.

1. For Sellers:

   • Sellers must be aware of depreciation recapture when determining the tax implications of a sale. While capital gains rates are generally favorable, the recapture of depreciation will push some or all of the gain into ordinary income tax territory, resulting in higher taxes.

   • Sellers should also consider strategies to minimize recapture, such as holding onto the property for longer periods or using tax deferral strategies like 1031 exchanges (for real property).

2. For Buyers:

   • Buyers need to be aware that depreciation recapture can affect the value of the assets they are acquiring. Understanding the remaining depreciable basis and the potential for recapture can impact the buyer’s overall return on investment.

   • Buyers may negotiate with the seller to allocate the purchase price in a way that minimizes the tax impact for both parties, for example, by allocating more of the purchase price to goodwill or other intangible assets, which are not subject to depreciation recapture.

Conclusion

The depreciation recapture rules under IRC Sections 1245 and 1250 are crucial tax considerations in any business transaction. Understanding how these sections apply to personal and real property can help both sellers and buyers plan for the tax consequences of a sale. By recognizing the implications of recapture and utilizing appropriate strategies, business owners can reduce their tax liabilities and improve the financial outcomes of their transactions.