What is Section 1250?
Section 1250 of the Internal Revenue Code states that if the accumulated depreciation exceeds the depreciation calculated using the straight-line method, the IRS will tax the gain on the sale of depreciated real property as ordinary income.
Section 1250 determines the amount of tax payable based on the type of property—whether residential or non-residential—while also taking into account the number of months the filer has owned the property.
- Section 1250 of the Internal Revenue Code states that if the accumulated depreciation exceeds the straight-line depreciation, the IRS will tax the gain on the sale of depreciated real property as ordinary income.
- Section 1250 applies primarily where a company depreciates its real estate using the accelerated depreciation method.
Section 1250 Basics
Section 1250 provides for the ordinary rate of taxation of gains from the sale of depreciable real property such as commercial buildings, warehouses, barns, rental properties and their structural components. However, tangible and intangible personal property and land area do not fall within the scope of this tax provision.
Section 1250 applies primarily to companies depreciating their real estate using the accelerated depreciation method, resulting in a larger deduction for the early useful life of the real estate than the straight-line method. Section 1250 states that if real property is sold at a purchase price that yields taxable income, and the owner depreciates the property using the accelerated depreciation method, the IRS tax the difference between actual depreciation and straight-line depreciation as ordinary income.
Because the IRS requires owners to depreciate all post-1986 real estate using the straight-line method, it is relatively rare for earnings to be considered ordinary income under Section 1250. If the owner disposes of the property as a gift transferred on death, sold as part of a similar transaction, or otherwise disposed of, there is no possible taxable gain.
Example application of Section 1250
To see a practical example of Section 1250, suppose an investor purchases $800,000 worth of real estate with a useful life of 40 years. After five years, using the accelerated depreciation method, the investor requests a cumulative depreciation expense of $120,000 and a cost basis of $680,000.
Let’s further assume that the investor sells the property for $750,000, resulting in a total taxable gain of $70,000. Since the accumulated straight-line depreciation is $100,000 (initial price of $800,000 divided by 40 years, multiplied by five years of use), the IRS must tax the $20,000 of actual depreciation that exceeds the straight-line depreciation as ordinary income. The IRS will then tax the remaining $50,000 in gross gains at the applicable capital gains tax rate.
Under Section 1250, the recovery of proceeds as ordinary income is limited to the actual proceeds recorded on the sale of real property. In our example, if an investor sold real estate for $690,000, resulting in a gain of $10,000, the IRS would only classify $10,000 as ordinary income, not an additional $20,000.