Section 1245 vs Section 1250 Property Explained

Section 1245 property includes tangible and intangible personal property subject to depreciation or amortization. For real estate investors, Section 1245 property primarily consists of building components reclassified through cost segregation into recovery periods of 20 years or less, including carpeting, appliances, fixtures, and certain land improvements such as parking lots, fencing, and landscaping.

The defining characteristic of Section 1245 property is full depreciation recapture as ordinary income upon disposition. When 1245 property vs 1250 property is sold, all accumulated depreciation on the Section 1245 components is recaptured and taxed at ordinary income rates to the extent of gain. This recapture applies regardless of whether the property was depreciated using accelerated methods or straight-line. For comprehensive guidance on Section 1245 depreciation recapture rules and calculations, property owners should review detailed recapture planning resources.

For cost segregation purposes, components identified as 5 year property, 7 year property, or 15 year land improvements become Section 1245 property. This classification enables accelerated depreciation and bonus depreciation eligibility during ownership but creates recapture obligations upon sale. The magnitude of recapture depends on accumulated depreciation claimed, which is typically substantial after cost segregation.

Section 1245 property includes both tangible personal property that is physically movable and tangible personal property that is attached to buildings but does not constitute structural components. The distinction between attached personal property and structural real property forms the basis for most cost segregation classifications. Items like carpet and appliances are clearly personal property despite being attached to buildings.

Section 1250 property consists of depreciable real property, primarily buildings and their structural components. For real estate, this includes residential rental buildings (27.5 year property) and commercial buildings (39 year property) along with structural elements such as foundations, framing, roofs, walls, and building systems that serve the structure as a whole rather than specific uses.

The recapture rules for Section 1250 property are more favorable than Section 1245 because only the excess of accelerated depreciation over straight-line depreciation is recaptured as ordinary income. Since buildings must use straight-line depreciation under current law, there is no excess accelerated depreciation to recapture, and the effective recapture exposure is limited to the unrecaptured Section 1250 gain taxed at 25% rather than ordinary rates. For detailed information on Section 1250 recapture and unrecaptured gain taxation, investors should consult comprehensive real property disposition resources.

After cost segregation, the remaining building basis continues to be Section 1250 property. If a building has $2,000,000 original basis and cost segregation reclassifies $500,000 into Section 1245 classes, the remaining $1,500,000 stays as Section 1250 property subject to favorable recapture treatment. This division creates a portfolio effect where some basis receives accelerated depreciation with full recapture and some receives slower depreciation with limited recapture.

The practical effect of Section 1250 treatment for straight-line depreciated buildings is that accumulated depreciation reduces basis and increases gain, with that gain attributable to prior depreciation taxed at the unrecaptured Section 1250 gain rate of 25% rather than capital gains rates. While this is less favorable than capital gains treatment, it is substantially better than the ordinary income recapture applicable to Section 1245 property.

The distinction between personal property vs real property drives both cost segregation classifications and Section 1245 vs 1250 determinations. Personal property for tax purposes includes tangible property that is movable or serves a specific use rather than the building generally, even if physically attached to a structure. Real property includes land, buildings, and structural components that are permanently affixed and serve the building as a whole.

Personal property attached to buildings can qualify as Section 1245 property if it does not lose its personal property character despite the attachment. Carpeting is personal property because it can be removed without damaging the building structure. Appliances are personal property because they serve a specific use rather than the building generally. Decorative fixtures are personal property when their function is aesthetic rather than structural.

Real property includes components that form the building structure, provide support, or serve the building as a whole rather than specific uses. Foundations, framing, roof structure, and exterior walls are clearly real property. HVAC systems, plumbing, and electrical systems that serve the entire building are real property. Interior walls that provide structure or fire separation may be real property depending on their function.

Land improvements present a unique category within the 1245 property vs 1250 property framework. Although land improvements like parking lots and landscaping are attached to land and serve the property, they are classified as Section 1245 property rather than Section 1250 property. This classification subjects them to full recapture but also makes them eligible for 15 year recovery periods and bonus depreciation.

Depreciation recapture is the process of converting previously claimed depreciation deductions from capital gain treatment back to ordinary income upon property disposition. The recapture rules prevent taxpayers from receiving the double benefit of ordinary deductions during ownership combined with capital gain treatment on the gain created by those deductions. The mechanics and magnitude of recapture differ significantly between Section 1245 and Section 1250 property.

For Section 1245 property, all accumulated depreciation is recaptured as ordinary income to the extent of gain. If a component cost $100,000, depreciated to zero, and is sold as part of a building sale that allocates $20,000 to that component, the entire $20,000 is ordinary income under Section 1245 recapture. If the allocated sale price were $120,000, producing $20,000 of gain above original basis, $100,000 would be Section 1245 recapture (the accumulated depreciation) and $20,000 would be capital gain.

For Section 1250 property depreciated using straight-line methods, there is no excess accelerated depreciation to recapture, so Section 1250 recapture is zero. However, the gain attributable to straight-line depreciation is taxed as unrecaptured Section 1250 gain at a maximum rate of 25% rather than the lower long term capital gains rates. If a building cost $1,000,000, had $400,000 accumulated straight-line depreciation, and sold for $1,200,000, the first $400,000 of gain is unrecaptured Section 1250 gain taxed at 25%, and the remaining $200,000 is capital gain.

The interaction between Section 1245 and Section 1250 recapture in cost segregation sales requires allocating the sale price among components. The purchase agreement may allocate prices, or the allocation may be determined through appraisal or residual methods. Each component's allocated sale price determines gain, and the character of that gain follows the component's classification as Section 1245 or Section 1250 property.

Cost segregation affects the 1245 1250 difference by converting building basis from Section 1250 property into Section 1245 property. Without cost segregation, most building basis is depreciated as Section 1250 property over 27.5 or 39 years. With cost segregation, 20% to 40% of basis is reclassified into shorter recovery periods and becomes Section 1245 property subject to full ordinary income recapture on disposition.

The recapture exposure created by cost segregation is the tradeoff for accelerated depreciation and bonus depreciation benefits during ownership. An owner receives larger upfront deductions that reduce current taxable income, but those deductions create future recapture obligations that increase taxable income upon sale. The economic benefit comes from the time value of money: current tax savings are worth more than future tax costs.

The magnitude of recapture depends on accumulated depreciation, which is typically substantial after cost segregation with bonus depreciation. If $500,000 of basis is reclassified and receives 100% bonus depreciation, that entire $500,000 becomes Section 1245 recapture exposure. If the property is sold at a gain years later, up to $500,000 of the gain will be recaptured as ordinary income rather than receiving capital gains treatment.

The recapture impact is reduced when properties are sold at losses or when accumulated depreciation exceeds the gain. Section 1245 recapture applies only to the extent of gain, so if a property is sold at a loss, no recapture occurs despite accumulated depreciation. Similarly, if a component depreciated by $100,000 but only produces $40,000 of gain, only $40,000 is recaptured even though $100,000 of depreciation was claimed.

Understanding Section 1245 vs Section 1250 recapture calculation helps investors quantify the disposition tax consequences of cost segregation. Consider a commercial building purchased for $2,000,000 with $500,000 land value and $1,500,000 depreciable basis. Without cost segregation, the entire $1,500,000 would be Section 1250 property depreciated over 39 years.

With cost segregation, assume $450,000 is reclassified as Section 1245 property and receives 100% bonus depreciation in year one. The remaining $1,050,000 stays as Section 1250 property and depreciates straight-line. After 5 years of ownership, the Section 1245 property has $450,000 accumulated depreciation. The Section 1250 property has approximately $135,000 accumulated depreciation. Total accumulated depreciation is $585,000.

If the property sells for $2,400,000 with $500,000 allocated to land, the building sale price is $1,900,000. Original depreciable basis was $1,500,000. Accumulated depreciation was $585,000. Adjusted basis is $915,000. Gain is $985,000. Of this gain, $450,000 is Section 1245 recapture (ordinary income), $135,000 is unrecaptured Section 1250 gain (taxed at 25%), and $400,000 is long term capital gain (taxed at preferential rates).

Without cost segregation, the same sale would have approximately $192,000 accumulated depreciation ($1,500,000 divided by 39 years times 5 years). Adjusted basis would be $1,308,000. Gain would be $592,000. All gain attributable to depreciation ($192,000) would be unrecaptured Section 1250 gain, and the remaining $400,000 would be capital gain. Cost segregation increased total depreciation by $393,000 but converted $450,000 from 25% unrecaptured gain treatment to ordinary income recapture treatment.

Strategies for managing Section 1245 vs 1250 recapture exposure include timing dispositions, structuring like kind exchanges, partial asset dispositions during ownership, and holding period optimization. While recapture cannot be permanently eliminated without disposing of the property at a loss, these strategies can defer or reduce the recapture impact depending on circumstances.

Timing dispositions to align with low income years can reduce the effective tax cost of ordinary income recapture. If an investor expects significantly lower marginal tax rates in future years due to retirement, other income changes, or anticipated tax law modifications, deferring sale to capture those lower rates reduces recapture cost. However, this strategy must be balanced against other economic considerations and the time value of money.

Partial asset dispositions during ownership can trigger recapture on specific components when they are retired or replaced. If carpet is replaced during ownership, the investor can claim a loss on the retired carpet and remove that basis from Section 1245 property subject to future recapture. This strategy requires proper documentation and component tracking but can meaningfully reduce aggregate recapture exposure over long holding periods with active renovation programs.

Holding property until death resets basis to fair market value under Section 1014, eliminating recapture exposure entirely. Heirs receive stepped up basis with no accumulated depreciation to recapture. For investors with estate planning objectives and long time horizons, holding appreciated properties until death avoids both recapture and capital gains taxes. This strategy works best when combined with effective estate tax planning. For a full review of exit strategies, see the guide on how to minimize depreciation recapture tax.

Like kind exchanges under Section 1031 defer both gain recognition and depreciation recapture when property is exchanged for like kind replacement property. Section 1245 recapture and Section 1250 recapture are both deferred in qualifying exchanges, and the exchanged basis carries forward into the replacement property with accumulated depreciation continuing to exist for future recapture upon eventual taxable sale.

For cost segregation components, Section 1031 deferral applies if the components are properly treated as part of the real property being exchanged. Personal property (Section 1245 property) can only be exchanged for like kind personal property, while real property (Section 1250 property) must be exchanged for like kind real property. When entire buildings are exchanged, both Section 1245 and Section 1250 components are treated as part of the real property exchange.

The basis allocation in replacement property after a Section 1031 exchange requires careful planning to maximize ongoing depreciation benefits while properly tracking recapture exposure. The exchanged basis generally cannot receive bonus depreciation because it is not acquired by purchase. New basis from cash or additional debt does qualify for bonus depreciation and cost segregation on the replacement property.

Multiple exchanges can defer recapture indefinitely across a series of properties. Investors pursuing build to wealth strategies using Section 1031 exchanges accumulate large amounts of deferred gain and recapture exposure across multiple properties. This strategy works effectively when combined with eventual step up in basis at death or when the investor ultimately accepts the recapture and capital gains tax on a final sale from a strong economic position.

Evaluating the tradeoff between upfront depreciation benefits and future Section 1245 recapture requires present value analysis that accounts for tax rates, holding period, and discount rate. The time value of money typically favors accepting recapture exposure in exchange for immediate deductions because current tax savings are worth more than future tax costs when properly discounted.

A simplified analysis compares the present value of tax savings from accelerated depreciation against the present value of incremental taxes from recapture. If cost segregation generates $200,000 of additional first year depreciation saving $70,000 in current taxes (35% rate), and the property is sold 7 years later triggering $200,000 of Section 1245 recapture costing $74,000 in taxes (37% rate), the present value of $70,000 today exceeds the present value of $74,000 in 7 years at any reasonable discount rate.

The analysis becomes more favorable for cost segregation when bonus depreciation accelerates even more depreciation into year one, when holding periods are long (10-plus years), when discount rates are high (8-10%), or when future tax rates are expected to be lower than current rates. The analysis becomes less favorable when holding periods are short (under 5 years), when discount rates are low, or when future rates are expected to increase.

Sensitivity analysis should test multiple scenarios because actual holding periods and tax rates are uncertain. Running scenarios with 5, 10, and 15 year holding periods and various future tax rate assumptions reveals the range of potential outcomes. For most realistic scenarios, the time value of money advantage of immediate deductions outweighs the recapture cost, supporting cost segregation decisions even after accounting for full recapture implications.