Section 1245: Depreciation Recapture for Cost Segregation

Section 1245 property encompasses tangible and intangible personal property subject to depreciation or amortization, as well as certain other specifically defined property types. For real estate investors, section 1245 property primarily consists of building components and improvements that can be depreciated over recovery periods of 20 years or less, including items reclassified through cost segregation studies.

The defining characteristic of section 1245 property is its treatment upon disposition. When section 1245 property is sold or otherwise disposed of, all accumulated depreciation claimed during the ownership period must be recaptured and taxed as ordinary income to the extent of gain realized. This recapture rule applies regardless of whether the property was depreciated using accelerated methods, straight-line methods, or bonus depreciation.

IRC Section 1245 specifically includes several categories of property commonly identified in cost segregation studies. Personal property such as furniture, fixtures, and equipment clearly falls within the section 1245 property definition. Building components that serve specific functions rather than the building generally, like specialty lighting or process equipment, are section 1245 property. Land improvements including parking lots, sidewalks, fencing, and landscaping are also section 1245 property despite being attached to land.

The classification of building components as section 1245 property versus section 1250 property depends on whether the component is considered personal property or real property for tax purposes. Cost segregation studies identify components that qualify as section 1245 property based on engineering analysis, physical characteristics, functional use, and applicable tax regulations. This reclassification from section 1250 to section 1245 property enables accelerated depreciation during ownership while creating recapture obligations upon disposition.

Section 1245 recapture rules require that all depreciation previously claimed on section 1245 property be recaptured as ordinary income when the property is disposed of in a taxable transaction. The recapture amount equals the lesser of two values: the total accumulated depreciation claimed over the ownership period, or the gain realized on the disposition. This ensures that the tax benefit received through depreciation deductions is reversed to the extent the property appreciated or maintained value.

The recapture calculation under section 1245 depreciation recapture rules is straightforward. If a component originally cost $50,000, accumulated $45,000 of depreciation, and is disposed of for $40,000 as part of a building sale, the entire $40,000 proceeds represent gain relative to the adjusted basis of $5,000. Because the gain ($35,000) is less than accumulated depreciation ($45,000), the full $35,000 of gain is section 1245 recapture taxed at ordinary income rates.

Section 1245 recapture applies only to the extent of gain realized. If property is disposed of at a loss, no recapture occurs despite accumulated depreciation claimed. This limitation means that in declining markets or when components have genuinely lost substantial value, the recapture exposure may be eliminated or reduced. However, when entire buildings are sold at gains, most section 1245 property components generate sufficient allocated gain to trigger full recapture of accumulated depreciation.

The recapture mechanism treats the recaptured amount as ordinary income rather than capital gain. This distinction is significant because ordinary income is taxed at rates up to 37% at the federal level plus applicable state taxes, while long-term capital gains receive preferential rates. The conversion of what would otherwise be capital gain into ordinary income represents the tax cost of having received accelerated depreciation benefits during the ownership period. Understanding this interaction between depreciation benefits and section 1250 depreciation recapture treatment helps investors evaluate complete lifecycle tax consequences. For the full overview of recapture rules, see the depreciation recapture guide.

Cost segregation studies identify building components that qualify as section 1245 property and reclassify them from longer recovery periods into 5, 7, or 15 year lives. This reclassification transforms components from section 1250 property subject to limited recapture into section 1245 property subject to full ordinary income recapture. The tradeoff is that section 1245 property receives accelerated depreciation and bonus depreciation eligibility, generating substantial upfront tax benefits.

When cost segregation identifies 25% to 35% of a building's basis as section 1245 property, that entire reclassified amount becomes subject to section 1245 recapture rules. If $500,000 of basis is reclassified and receives 100% bonus depreciation, that $500,000 of accumulated depreciation creates $500,000 of potential recapture exposure. Upon building sale, up to $500,000 of the gain allocated to those components will be recaptured as ordinary income rather than receiving capital gains treatment.

The interaction between cost segregation and section 1245 property classification affects both acquisition year tax benefits and disposition year tax consequences. During acquisition and early ownership years, reclassification into section 1245 property generates substantial tax savings through accelerated depreciation. These savings can be used to improve cash flow, reduce debt, fund additional investments, or build reserves. The tax savings are real and immediate.

Upon disposition, the accumulated depreciation on section 1245 property components must be recaptured to the extent of gain. This creates additional tax liability in the sale year compared to a scenario without cost segregation. However, the time value of money typically makes the early tax savings more valuable than the later tax cost. Present value analysis accounting for the timing of tax savings versus recapture costs generally supports cost segregation implementation despite section 1245 recapture obligations.

Section 1245 property examples in commercial and residential real estate are diverse and property-type specific. Understanding common categories helps investors anticipate which building components will be subject to section 1245 recapture after cost segregation studies. The following examples represent typical section 1245 property identified across various building types and uses.

Personal property affixed to buildings includes carpeting and vinyl flooring, window coverings and blinds, appliances in residential or hospitality properties, removable partitions and modular furniture systems, and decorative light fixtures that serve aesthetic rather than general building lighting functions. These items are clearly personal property despite being attached to the building structure, and they uniformly qualify as section 1245 property with 5 or 7 year recovery periods.

Land improvements constitute a major category of section 1245 property for most real estate holdings. Parking lot paving, striping, and related improvements receive 15 year recovery periods and section 1245 property treatment. Sidewalks, curbing, and site concrete work unrelated to building structure are section 1245 property. Fencing, gates, and security barriers are section 1245 property. Landscaping including planted areas, irrigation systems, and decorative features qualifies as section 1245 property. Site lighting serving parking areas and walkways is section 1245 property.

Specialty building systems and components that serve specific functions rather than the building generally can qualify as section 1245 property. Examples include restaurant kitchen equipment and built-in cooking systems, retail display fixtures and specialized lighting, medical facility specialty electrical and plumbing serving specific equipment, data center raised flooring and specialty electrical distribution, and manufacturing facility process piping and equipment supports. These components are analyzed based on their specific function and relationship to the building.

Calculating section 1245 depreciation recapture requires determining three key values: the original cost basis of the section 1245 property, the total accumulated depreciation claimed during ownership, and the amount realized upon disposition allocated to the section 1245 property. The recapture amount equals the lesser of accumulated depreciation or the gain realized, with the recaptured amount taxed as ordinary income.

Consider a detailed calculation example for a commercial building purchased for $3,000,000 including $600,000 land value, resulting in $2,400,000 depreciable basis. A cost segregation study reclassifies $720,000 into section 1245 property receiving 100% bonus depreciation. The remaining $1,680,000 is section 1250 property depreciated straight-line over 39 years. After 6 years of ownership, accumulated depreciation on section 1245 property is $720,000 (all claimed year one through bonus depreciation). Accumulated depreciation on section 1250 property is approximately $258,000 (six years of straight-line depreciation).

The building is sold for $3,600,000 with $600,000 allocated to land and $3,000,000 to improvements. The sale price allocation assigns $700,000 to section 1245 property components and $2,300,000 to section 1250 property based on appraisal. For section 1245 property, the adjusted basis is zero ($720,000 original basis minus $720,000 accumulated depreciation). Gain on section 1245 property is $700,000. Because accumulated depreciation ($720,000) exceeds the gain ($700,000), the entire $700,000 gain is section 1245 recapture taxed as ordinary income.

For the section 1250 property, adjusted basis is $1,422,000 ($1,680,000 original basis minus $258,000 accumulated depreciation). Gain is $878,000 ($2,300,000 sale price minus $1,422,000 adjusted basis). Because the building used straight-line depreciation, section 1250 recapture is zero, but $258,000 is unrecaptured section 1250 gain taxed at 25%, and the remaining $620,000 is long-term capital gain. Total ordinary income from section 1245 recapture is $700,000, creating significantly higher tax cost than the building would have generated without cost segregation.

IRC Section 1245 tax treatment converts depreciation deductions that offset ordinary income during ownership back into ordinary income upon disposition through the recapture mechanism. This symmetrical treatment ensures that taxpayers do not permanently convert ordinary income into capital gains through depreciation deductions. The tax rates applicable to section 1245 recapture are the same ordinary income rates that applied when the depreciation deductions were claimed, creating an economically neutral long-term result absent time value of money considerations.

The ordinary income characterization of section 1245 recapture means the recaptured amount is subject to the taxpayer's marginal tax rate in the year of disposition. For individuals, federal ordinary income rates range from 10% to 37% depending on taxable income. State income taxes apply in addition to federal taxes in most jurisdictions. The combined federal and state effective rate on section 1245 recapture can easily exceed 40% for high income taxpayers in high tax states. For a detailed analysis of these rates, see the depreciation recapture tax rate guide.

Section 1245 recapture is reported on Form 4797 Sales of Business Property as ordinary income. The recaptured amount is calculated by the taxpayer or tax preparer based on accumulated depreciation records and the gain realized on disposition. For properties with cost segregation studies, detailed component tracking is essential to accurately calculate section 1245 recapture amounts and properly allocate the sale price among section 1245 property components and section 1250 property.

The interaction between section 1245 recapture and other tax provisions requires careful coordination. Self-employment taxes do not apply to section 1245 recapture from real estate sales because the recapture is investment income rather than trade or business income for most investors. Net investment income tax at 3.8% may apply to section 1245 recapture for high income taxpayers. Passive activity loss rules can limit the ability to offset section 1245 recapture with suspended passive losses depending on the specific facts and circumstances of the disposition.

The relationship between section 1245 property designation and ordinary depreciation during ownership creates the fundamental economic tradeoff of cost segregation. Section 1245 property receives accelerated depreciation and bonus depreciation eligibility, generating larger deductions in early ownership years compared to section 1250 property. These enhanced deductions reduce ordinary income at the taxpayer's marginal rate during profitable operating years.

Without cost segregation, building components depreciate as part of the building structure using 27.5 or 39 year straight-line recovery periods. This depreciation provides steady annual deductions over the entire recovery period. Upon disposition, the accumulated straight-line depreciation on buildings is subject to limited section 1250 recapture (zero for straight-line methods) and unrecaptured section 1250 gain treatment capped at 25% rather than ordinary income rates.

With cost segregation, components reclassified as section 1245 property receive accelerated depreciation over 5, 7, or 15 year recovery periods. When bonus depreciation is available, the entire reclassified basis can be deducted in year one. This creates dramatically larger first year deductions compared to straight-line building depreciation. However, upon disposition, all of this accelerated depreciation is recaptured as ordinary income rather than receiving preferential capital gains or unrecaptured section 1250 gain treatment.

The time value of money heavily influences this comparison. A dollar of tax savings today is worth more than a dollar of tax cost in 5, 10, or 15 years when properly discounted. Even though section 1245 recapture ultimately taxes the same accumulated depreciation at ordinary rates that produced ordinary income deductions, the timing difference creates substantial present value benefits. Most investors find that the immediate cash flow improvement from accelerated depreciation justifies accepting the future recapture obligation.

Section 1245 recapture is triggered by disposition events including outright sales, exchanges, involuntary conversions, and certain other transfers. The timing of recapture recognition depends on whether the disposition is a taxable transaction or qualifies for deferral treatment under specific Code provisions. Understanding the timing rules helps investors plan dispositions and manage recapture obligations strategically.

For taxable sales, section 1245 recapture is recognized in the year of sale regardless of whether the seller receives cash, installment notes, or other consideration. The full recapture amount is included in ordinary income in the sale year even if the gain is reported under the installment method for capital gain purposes. This creates potential tax payment obligations before full cash proceeds are received, requiring careful planning for seller-financed transactions.

Partial asset dispositions during ownership trigger section 1245 recapture on the specific components retired or disposed of. If carpeting is replaced after 4 years, the adjusted basis of the retired carpet is compared to any salvage value or insurance proceeds received. If the retirement generates a gain, section 1245 recapture applies to accumulated depreciation on the retired carpet. If the retirement generates a loss, no recapture occurs and an ordinary loss is recognized.

Component retirements and partial dispositions provide opportunities to accelerate losses and reduce future recapture exposure. When building components are replaced during ownership, properly identifying and retiring the old components removes them from the section 1245 property inventory. The retirement typically generates an ordinary loss because components rarely have salvage value exceeding their depreciated basis. This reduces both the accumulated depreciation and the potential recapture exposure when the building is eventually sold.

Managing section 1245 recapture exposure involves a combination of timing strategies, transaction structuring, and long-term planning that recognizes the tradeoffs between immediate tax benefits and future tax costs. While recapture cannot be permanently eliminated through normal taxable sales, several strategies can defer, reduce, or mitigate the tax impact depending on investor circumstances and objectives.

Holding property until death provides the most complete elimination of section 1245 recapture obligations. When property passes to heirs, the basis is stepped up to fair market value under Section 1014, eliminating all accumulated depreciation and recapture exposure. Heirs receive the property at current value with zero depreciation recapture obligations. This strategy works particularly well for investors with estate planning objectives and sufficient other liquidity to avoid forced sales during lifetime.

Timing dispositions strategically around income fluctuations can reduce the effective tax cost of section 1245 recapture. If an investor expects to have significantly lower marginal tax rates in future years due to retirement, business changes, or other income reductions, deferring property sales to those low income years reduces the tax rate applied to recapture income. The strategy requires balancing tax savings against forgone sale proceeds and continued property ownership obligations. For a full comparison of recapture reduction strategies, see the guide on cost segregation before selling a property.

Utilizing partial asset dispositions and component tracking during ownership actively manages section 1245 recapture exposure by removing components as they are retired. When carpet is replaced, appliances are upgraded, or parking lots are repaved, the old components can be identified and retired with recognition of ordinary losses. These losses offset current income and remove accumulated depreciation from future recapture calculations. The strategy requires detailed record keeping and proper segregation of component costs to support retirement calculations.

Like-kind exchanges under Section 1031 defer section 1245 recapture by postponing gain recognition on qualifying exchanges of real property. When an investor exchanges a building containing section 1245 property components for replacement real property, the exchange defers both capital gain recognition and depreciation recapture. The deferred recapture carries forward into the replacement property and remains a future obligation when the replacement property is eventually sold in a taxable transaction.

The mechanics of section 1245 recapture deferral in Section 1031 exchanges require that section 1245 property be treated as part of the real property being exchanged rather than as separate personal property. When entire buildings are exchanged, including both section 1250 property (the building structure) and section 1245 property (personal property components and land improvements), the exchange qualifies as a real property exchange deferring all gain and recapture.

The exchanged basis carries forward into replacement property with accumulated depreciation continuing to exist for recapture purposes. If property with $600,000 of section 1245 recapture exposure is exchanged for replacement property, that $600,000 of deferred recapture becomes recapture exposure on the replacement property. When the replacement property is eventually sold without further exchange, both the original deferred recapture and any new depreciation claimed on the replacement property are subject to recapture.

Multiple successive exchanges can defer section 1245 recapture indefinitely across a series of properties. Investors using build-to-wealth strategies with repeated Section 1031 exchanges accumulate deferred gain and recapture exposure over decades and multiple properties. The deferred recapture is only recognized when the investor completes a taxable sale without exchanging or when the property passes to heirs with a stepped-up basis. This deferral strategy combined with eventual basis step-up at death can eliminate recapture obligations entirely while providing depreciation benefits across multiple properties over a lifetime.