IRC 1245 and IRC 1250 Depreciation Recapture: Cost Segregation, OBBBA Bonus Depreciation, and Real Property Gain Planning Guide

Section 1: IRC 1245 Recapture Mechanics

The Gain Bifurcation Framework

When a taxpayer sells or exchanges depreciable personal property at a price above its adjusted basis, the recognized gain is bifurcated into two components under IRC 1245(a)(1). The first component is ordinary income: the gain is recharacterized as ordinary income to the extent it does not exceed the "recomputed basis" minus the adjusted basis at the time of sale. The "recomputed basis" equals the property's adjusted basis PLUS all depreciation and amortization allowed or allowable on the property since December 31, 1961. The second component, if any, is Section 1231 gain: the portion of the recognized gain that exceeds the recomputed basis minus adjusted basis retains its Section 1231 character and may qualify for long-term capital gain treatment.

In practice, when a taxpayer has fully recovered an asset's cost through depreciation (adjusted basis equals zero), the ENTIRE gain on sale up to the original purchase price is Section 1245 ordinary income. Only amounts received above the original cost would potentially be Section 1231 gain. Cite: IRC 1245(a)(1).

The "Allowed or Allowable" Trap

The recomputed basis computation includes depreciation that was "allowed OR allowable." This is not a drafting technicality. It is a substantive rule that catches taxpayers who failed to claim depreciation deductions in prior years. Cite: Treas. Reg. 1.1245-2(a); applicable case law on the allowed-or-allowable standard.

Under the "allowable" prong, the IRS treats a taxpayer's adjusted basis as having been reduced by the maximum depreciation that could have been claimed under the applicable method, convention, and recovery period, regardless of whether the taxpayer actually took the deduction on their return. The effect: a taxpayer who failed to depreciate a machine for five years does not preserve basis for recapture purposes. The IRS will treat the basis as having been reduced by the five years of allowable depreciation, and the same amount will be counted toward the recapture computation on sale.

Affected scenarios include: taxpayers who omitted depreciation by oversight; taxpayers who switched depreciation methods and failed to account for prior-period amounts correctly; taxpayers who applied incorrect partial-year conventions; and taxpayers who failed to claim bonus depreciation in a year it was available. In all cases, the solution (if the error was not previously corrected via a method change under Rev. Proc. 2023-24 or predecessor procedures) is to address the missed depreciation prospectively or via Form 3115 before disposition, not to assume the basis is preserved.

Scope of IRC 1245 Property

IRC 1245(a)(3) defines the scope of Section 1245 property. The category includes: Cite: IRC 1245(a)(3); Treas. Reg. 1.1245-3.

• Depreciable personal property: all tangible personal property subject to depreciation or amortization, including machinery, equipment, vehicles, computers, and furniture.
• Pre-1987 ACRS real property: certain real property placed in service before January 1, 1987, that was subject to the Accelerated Cost Recovery System (ACRS) and held under an accelerated method, is treated as Section 1245 property for recapture purposes.
• Section 197 intangibles: goodwill, customer lists, covenants not to compete, licenses, and other intangibles amortized over the 15-year period under IRC 197 are Section 1245 property. The accumulated 15-year amortization creates recapture potential on sale or disposition of the intangible. Practitioners who negotiate asset purchase allocations must model the Section 197 recapture on any intangibles transferred.
• Certain leasehold improvements and structural components reclassified via a cost segregation study from Section 1250 building to shorter-lived personal property categories.
• Single-purpose agricultural and horticultural structures and certain railroad grading and tunnel bores.

What is NOT Section 1245 property (post-1986): residential rental property (27.5-year MACRS) and nonresidential real property (39-year MACRS) placed in service after 1986 are generally Section 1250 property, not Section 1245 property. The distinction is critical: Section 1250 property is subject to the 25% unrecaptured gain rate rather than the full ordinary income Section 1245 recapture rule, as detailed in Section 3 of this guide. The exception: components reclassified via cost segregation cease to be Section 1250 property and become Section 1245 property.

Pass-Through Entities: S-Corps and Partnerships

Section 1245 recapture is an item of income with a specific character: ordinary income. That character passes through to shareholders and partners and is reported as ordinary income on each owner's return. Cite: IRC 1366 (S-corporations); IRC 702(b) (partnerships).

For partnerships, IRC 751(c) treats potential Section 1245 and Section 1250 recapture as "unrealized receivables" for hot-asset purposes. When a partner sells their partnership interest, IRC 751 requires the selling partner to recognize ordinary income to the extent of their allocable share of the partnership's accumulated recapture potential. The partnership is required to maintain asset-level depreciation records to support this computation. A Section 754 election affects the basis adjustments under IRC 743(b) for the purchasing partner but does NOT eliminate or offset the recapture potential on a subsequent disposition of the underlying assets. Cite: IRC 751(c); Treas. Reg. 1.751-1. See also IRC 754 Election and Partnership Basis Adjustment: Practitioner Guide and IRC 704(c) Layer Tracking and Reverse 704(c) Book-Up: Tiered Partnerships Guide for the basis adjustment and allocation mechanics that interact with recapture planning. For audit exposure in the BBA regime, see the Partnership BBA Audit and CPAR Push-Out Election Guide.

IRC 1245(b) Exceptions: When Recapture Is Not Recognized

IRC 1245(b) provides four categories of exceptions where recapture income is not recognized at the time of transfer. Each exception preserves the recapture potential in the transferee's basis rather than permanently eliminating it, with one important exception (death): Cite: IRC 1245(b).

• Gifts (IRC 1245(b)(1)): no recapture is recognized on a gift transfer. The donee takes a carryover basis under IRC 1015 (adjusted for any gift tax attributable to net appreciation) and inherits the full recapture potential. A gift of appreciated depreciable equipment merely defers the recapture to the donee's eventual sale.
• Transfers at death (IRC 1245(b)(2)): no recapture is recognized at the decedent's death. The beneficiary receives a stepped-up (or stepped-down) basis to fair market value under IRC 1014, permanently eliminating both the Section 1245 recapture potential and the unrecaptured Section 1250 gain. For taxpayers holding heavily depreciated property with large accumulated recapture, this is one of the most significant income tax planning levers available. Compare IRC 2032 alternate valuation date planning for the estate tax overlay.
• Tax-free corporate reorganizations under IRC 368 (IRC 1245(b)(3)): no recapture to the extent gain is not recognized in the reorganization. Recapture potential is preserved in the carryover basis of the successor corporation.
• IRC 1033 involuntary conversions (IRC 1245(b)(4)): no recapture to the extent gain is not recognized. The recapture potential carries over to the replacement property.
• IRC 1031 like-kind exchanges (IRC 1245(b)(4)): no recapture to the extent gain is not recognized. ALL accumulated prior depreciation carries over into the replacement property's lower carryover basis. The recapture is deferred, not eliminated; when the replacement property is eventually sold outside a like-kind exchange, the accumulated recapture from both the relinquished and the replacement property is recognized at once. See Section 5 for the full like-kind exchange analysis.

Corporate Recapture (C-Corps and S-Corps)

For C-corporations, all capital gains are already taxed at ordinary income rates; accordingly, the Section 1245 recapture distinction is primarily relevant for state tax apportionment, AMT planning, and exit structure analysis rather than for federal income tax rate arbitrage. For C-corp exit transactions involving appreciated depreciable property, the double-taxation exposure on the ordinary income from recapture (corporate-level tax, then shareholder-level tax on distribution) is a significant planning consideration.

For S-corporations, IRC 1245 recapture retains its ordinary income character and passes through to shareholders under IRC 1366. However, if the S-corporation holds assets that were appreciated at the time the S-corp election was made, the IRC 1374 "built-in gains" tax may apply. The IRC 1374 tax is a corporate-level tax imposed on the S-corp's net recognized built-in gain during the recognition period (currently five years under IRC 1374(d)(7)). This corporate-level tax applies IN ADDITION to (not instead of) the pass-through of ordinary income to shareholders. Cite: IRC 1374; IRC 1374(d)(7). Hedge all IRC 1374 specifics to IRS.gov and the IRC 1374 guidance in effect at the time of the transaction. See IRC 1374 Built-In Gains Tax: S-Corp Conversion Practitioner Guide for the full built-in gains analysis.

Section 2: OBBBA QPP Bonus Depreciation and the Recapture Acceleration Risk

What OBBBA Changed for First-Year Expensing

The One Big Beautiful Act (OBBBA) reinstated 100% additional first-year depreciation (bonus depreciation) under IRC 168(k) for Qualified Production Property (QPP). QPP, as defined under OBBBA, means tangible depreciable personal property placed in service in the United States after January 20, 2025. Under the OBBBA bonus depreciation rule, the ENTIRE cost basis of eligible QPP is deducted in the year the property is placed in service, reducing its adjusted basis to zero (or near zero, depending on any land or non-qualifying allocation). Hedge all OBBBA QPP definition requirements, phase-in rules, and placement-in-service date requirements to enacted OBBBA and current IRS.gov guidance. Final regulations may not yet have been issued as of this writing.

The Recapture Math: 100% Expense, 100% Ordinary Income on Sale

The Section 1245 recapture consequence of 100% OBBBA expensing is straightforward and severe. Consider the following scenario:

The entire $600,000 gain is ordinary income. There is no Section 1231 capital gain. The taxpayer received a deduction worth $1,000,000 x (ordinary rate) in Year 1 and then recognized ordinary income of $600,000 in Year 2. The net tax benefit of the OBBBA expensing on an immediate resale is the time value of deferring tax on the $400,000 that was depreciated but NOT recaptured (because the property sold below cost), plus the deferral benefit on the $600,000 recaptured amount for one year.

Planning Point: When OBBBA Bonus Depreciation Hurts Net After-Tax Return

If the taxpayer's ordinary income rate meaningfully exceeds their long-term capital gain rate (as is typical for individuals in higher brackets), and the property is expected to be sold within a short holding period without a like-kind exchange, taking 100% OBBBA bonus depreciation converts future capital gain into ordinary income recapture. The NPV of the faster deduction may not compensate for the permanent rate increase on recapture at sale. Practitioners should model all three scenarios for clients with significant depreciable asset turnover:

1. 100% OBBBA bonus depreciation, short hold, sale: maximum recapture exposure, all ordinary income.
2. 100% OBBBA bonus depreciation, long hold until death: maximum recapture elimination via IRC 1014 stepped-up basis; full deduction benefit with no recapture tax.
3. Straight-line MACRS, sale: partial Section 1245 recapture (or Section 1250 bucket at 25% for reclassified real property); Section 1231 gain on any appreciation above original cost.

OBBBA QPP Scope Boundaries

OBBBA's 100% bonus depreciation applies only to tangible depreciable personal property that qualifies as QPP. Several asset categories are outside the QPP definition and are not subject to the 100% expensing rule:

• Land: not depreciable; no Section 1245 recapture issue (but land allocations affect the total depreciable basis available for QPP expensing).
• Buildings (Section 1250 property): 27.5-year residential rental and 39-year nonresidential real property are not QPP and are not eligible for 100% OBBBA bonus depreciation; they remain subject to the Section 1250 / unrecaptured Section 1250 gain framework.
• IRC 197 intangibles: goodwill, covenants, customer lists, and other 15-year intangibles are not tangible personal property and are not QPP; they are amortized under IRC 197 and subject to Section 1245 recapture on the amortization taken.

Purchase price allocations in acquisition transactions must clearly identify the QPP component, the non-QPP personal property, the Section 1250 real property, land, and intangibles. The QPP allocation will be fully recaptured as ordinary income on any subsequent sale; the allocation should reflect this economic reality. Hedge all OBBBA QPP mechanics, definitions, and limitations to enacted OBBBA and IRS.gov guidance current as of the date of any transaction.

Section 3: IRC 1250 -- Real Property Depreciation and the 25% Rate Bucket

The Section 1250 Ordinary Income Threshold

Section 1250 imposes ordinary income recapture only on "additional depreciation" taken on Section 1250 real property. "Additional depreciation" is defined as the excess of actual depreciation taken over the straight-line depreciation that would have been allowable for the same period using the applicable straight-line rate and recovery period. Cite: IRC 1250(b)(1).

For post-1986 MACRS property (residential rental property at 27.5 years; nonresidential real property at 39 years), depreciation is computed under the straight-line method only. There is no "additional depreciation" above straight-line because straight-line IS the applicable method. The result: for the vast majority of MACRS real property, Section 1250 ordinary income recapture is zero.

When Section 1250 Ordinary Income Can Arise

Section 1250 ordinary income recapture is not extinct; it arises in the following circumstances:

• Pre-1987 ACRS real property: Accelerated Cost Recovery System real property placed in service between 1981 and 1986 used accelerated methods (175% or 200% declining balance on certain classes). The excess of ACRS accelerated depreciation over straight-line is "additional depreciation" subject to Section 1250 ordinary income recapture. Practitioners with long-held pre-1987 real estate assets must compute this amount on any disposition. Hedge the ACRS/MACRS transition rules to applicable IRS transition guidance.
• Certain accelerated methods on leasehold improvements or structural components depreciated prior to MACRS using an accelerated method above straight-line.

Unrecaptured Section 1250 Gain: The 25% Rate Capital Gains Bucket

Even when Section 1250 produces no ordinary income recapture (as with most MACRS real property), the TOTAL straight-line depreciation taken on Section 1250 property creates a distinct, partially-favorable tax consequence: the "unrecaptured Section 1250 gain." Cite: IRC 1(h)(1)(D).

Under IRC 1(h)(1)(D), long-term capital gain from the sale of Section 1250 real property is taxed at a maximum rate of 25% to the extent it does not exceed the total depreciation allowed or allowable on the property (i.e., the "unrecaptured" amount, meaning the depreciation that Section 1250 did not recapture as ordinary income). The 25% rate is a cap: taxpayers in lower brackets may pay a lower rate, but the rate cannot drop below the taxpayer's marginal long-term capital gain rate for the unrecaptured bucket.

Calculating Unrecaptured Section 1250 Gain

The "unrecaptured Section 1250 gain" equals the LESSER of:

1. The total depreciation allowed or allowable on the Section 1250 property; or
2. The recognized Section 1231 gain from the sale (after any netting with Section 1231 losses).

Practical example: a taxpayer purchased a nonresidential building for $2,000,000 in 2005, took $500,000 of straight-line 39-year MACRS depreciation over the holding period, and sold in 2025 for $3,200,000. Adjusted basis at sale: $1,500,000. Total gain: $1,700,000. Section 1250 ordinary income: $0 (MACRS straight-line, no "additional depreciation"). Unrecaptured Section 1250 gain: $500,000 at a maximum 25% rate. Remaining Section 1231 gain: $1,200,000 at standard long-term capital gain rates (0%, 15%, or 20% depending on total income). Plus: NIIT of 3.8% may apply to net investment income above the applicable threshold. Cite: IRC 1411 for the NIIT; hedge applicable thresholds to current IRS.gov guidance.

NIIT Overlay on the 25% Bucket

For high-income individual taxpayers, the net investment income tax (NIIT) under IRC 1411 applies an additional 3.8% surcharge on net investment income above the applicable modified adjusted gross income threshold. Gain from the sale of real property that is not subject to self-employment tax (passive rental activity, for example) is typically included in net investment income. The unrecaptured Section 1250 gain, while taxed at a maximum 25% rate, is still capital gain for NIIT purposes and is subject to the 3.8% surcharge if the threshold is met. The combined effective maximum rate on unrecaptured Section 1250 gain for a high-income individual is thus 25% + 3.8% = 28.8%. Cite: IRC 1411; hedge applicable MAGI thresholds and NII definition to IRS.gov as they are adjusted for inflation.

Section 4: Cost Segregation and the Recapture Trap

What Cost Segregation Does to Depreciation Character

A cost segregation study is an engineering-based tax analysis that reclassifies components of a building from the structural "building" category (Section 1250 property: 27.5-year residential or 39-year nonresidential, straight-line) to personal property or land improvement categories (Section 1245 property: typically 5-year or 7-year for personal property, 15-year for land improvements, all eligible for accelerated or bonus depreciation). The reclassification is supported by IRC 1245(a)(3), the MACRS asset class tables in Rev. Proc. 87-56, and current IRS.gov cost segregation audit techniques guidance. Cite: IRC 1245(a)(3); Rev. Proc. 87-56; IRS.gov Cost Segregation Audit Techniques Guide.

The consequence of reclassification is twofold. First, the taxpayer obtains faster depreciation deductions on the reclassified components (5-year, 7-year, or 15-year recovery vs. 27.5 or 39 years). Second, those reclassified components are now Section 1245 property. On a future sale, the depreciation taken on the reclassified components is subject to FULL ordinary income recapture under IRC 1245(a)(1), NOT the 25% unrecaptured Section 1250 gain rate.

The Recapture Trade-Off Analysis

The cost segregation decision is a time-value-of-money and rate-differential analysis that cannot be resolved with a default answer. The relevant variables are:

The net present value of the faster depreciation benefit must exceed the marginal rate difference between ordinary income and the 25% rate on the recaptured amount, discounted at the appropriate time horizon. For assets expected to sell within three to five years at a significant gain, the trade-off often disfavors aggressive cost segregation (particularly combined with OBBBA full expensing), unless a like-kind exchange or death is the planned exit.

Combined OBBBA + Cost Segregation: The Maximum Recapture Risk Profile

The combination of cost segregation reclassification (converting Section 1250 components to Section 1245 property) and OBBBA 100% bonus depreciation on the reclassified components creates the maximum recapture risk profile in the current environment:

1. The building is acquired and a cost segregation study is performed at acquisition.
2. The reclassified personal property components (now QPP under OBBBA) are 100% expensed in Year 1; adjusted basis of reclassified components goes to zero.
3. The remaining building (Section 1250) continues on a 27.5-year or 39-year straight-line MACRS schedule.
4. On a taxable sale in Year 3, for example: (a) ALL of the reclassified-component gain (up to the original cost of the components) is Section 1245 ordinary income; (b) the building depreciation taken is unrecaptured Section 1250 gain at 25%; (c) any appreciation above original total purchase price is Section 1231 capital gain.

The taxpayer has effectively elected to pay ordinary income rates on the fastest-declining components of the property. For a building where cost segregation identifies 20-30% of cost as 5-year or 7-year personal property, and those components are 100% expensed under OBBBA, the ordinary income at sale on the reclassified components can be substantial. Hedge all OBBBA QPP and cost segregation mechanics to enacted OBBBA, Rev. Proc. 87-56, and IRS.gov guidance current at the time of the transaction.

Look-Back Cost Segregation and "Catch-Up" Depreciation

A taxpayer who acquired property in a prior year without performing a cost segregation study may be able to file a Form 3115 (Application for Change in Accounting Method) to claim "catch-up" depreciation on previously acquired property as a Section 481(a) adjustment in the current tax year. The catch-up depreciation represents the difference between the depreciation that would have been taken under the segregated asset classification and what was actually taken on the unsegregated building class. The subsequent recapture analysis applies to the TOTAL depreciation "allowed or allowable," including the catch-up amount recognized in the Section 481(a) year. Practitioners must model the recapture on the full post-look-back basis position, not only the prospective depreciation. Hedge all Form 3115 and Section 481(a) mechanics to Rev. Proc. 2023-24 (or its current successor) and IRS.gov guidance.

Section 5: Like-Kind Exchanges and Other Deferral Strategies

IRC 1031 Like-Kind Exchange: Deferral, Not Elimination

A qualifying IRC 1031 like-kind exchange defers ALL gain recognition on the relinquished property, including Section 1245 recapture and Section 1250 unrecaptured gain, to the extent the exchange qualifies and no taxable boot is received. Cite: IRC 1031(a)(1); IRC 1245(b)(4). For the full mechanics of identification periods, qualified intermediaries, boot calculations, and like-kind requirements, see IRC 1031 Like-Kind Exchange and Qualified Intermediary: Practitioner Guide.

However, the exchange defers, not eliminates, the recapture. The replacement property takes a carryover basis (basis of the relinquished property, decreased by any boot received and increased by any gain recognized and any additional consideration paid). The replacement property's lower carryover basis embeds ALL of the prior depreciation from the relinquished property. On the eventual sale of the replacement property outside a like-kind exchange, the accumulated recapture from BOTH the relinquished property (carried over) and the replacement property (its own depreciation) is recognized at once.

The "Stacking" Problem in Serial Like-Kind Exchanges

Taxpayers who use repeated IRC 1031 exchanges over a long period accumulate recapture potential across multiple generations of replacement properties. Each exchange preserves the prior recapture and layers the new property's depreciation on top. At the terminal sale (the first taxable sale outside an exchange), all accumulated recapture from every property in the chain is recognized. Practitioners advising clients with long exchange histories must reconstruct the recapture basis from every relinquished property in the chain, which requires maintaining exchange records spanning decades. This is a significant recordkeeping and audit-exposure issue.

Death as the Ultimate Recapture Terminator

IRC 1245(b)(2) provides that no Section 1245 recapture is recognized at the decedent's death. Under IRC 1014, the beneficiary receives a basis equal to the fair market value of the property at the date of death (or alternate valuation date under IRC 2032), permanently eliminating both the Section 1245 recapture potential and the unrecaptured Section 1250 gain bucket on the decedent's property. No depreciation recapture tax is EVER imposed on the accumulated depreciation, regardless of the amount.

For clients holding heavily depreciated depreciable property (high accumulated Section 1245 recapture or large unrecaptured Section 1250 gain) who have both estate planning and income tax planning objectives, holding until death is frequently the optimal exit strategy. This is particularly relevant for real estate with long exchange histories where the basis has been stepped down through multiple relinquishments. Cite: IRC 1245(b)(2); IRC 1014. Note: IRC 1014 is subject to potential future legislative changes; confirm current law at IRS.gov before relying on the stepped-up basis benefit in any specific transaction.

Installment Sales Cannot Defer Recapture

Installment sale reporting under IRC 453 allows a seller to recognize gain ratably as payments are received over multiple tax years, deferring the tax cost. However, this deferral is NOT available for Section 1245 or Section 1250 ordinary income recapture. Cite: IRC 453(i)(1). Under IRC 453(i)(1), if the installment sale involves property subject to recapture under IRC 1245 or IRC 1250, the ENTIRE recapture income must be recognized in the year of sale (the year the installment obligation is created), regardless of when payments are actually received. Only the Section 1231 gain ABOVE the recapture amount may be deferred via installment reporting.

S-Corp and C-Corp Exit: Built-In Gains and Double Tax

For S-corporations disposing of appreciated depreciable property during the IRC 1374 recognition period (five years from the date of the S-corp election, per IRC 1374(d)(7)), the built-in gains tax applies to net recognized built-in gain at the highest corporate rate. This is a corporate-level tax on gain that was "built in" (accrued) before the S-election date. It applies in addition to the pass-through of ordinary income character from Section 1245 recapture to shareholders. The combined federal burden on Section 1245 recapture during the recognition period is thus: (a) corporate-level IRC 1374 tax, plus (b) shareholder-level ordinary income on the pass-through. Cite: IRC 1374; IRC 1374(d)(7). Hedge all IRC 1374 mechanics, including the recognition period end date and interaction with prior S-corp NOL carryforwards, to IRS.gov and applicable regulations current as of the transaction date. See IRC 1374 Built-In Gains Tax: S-Corp Conversion Practitioner Guide.

For C-corporations, there is no distinction between capital gain and ordinary income at the federal level (all are taxed at the 21% flat corporate rate). Section 1245 recapture is therefore a state tax and AMT consideration for C-corps, as well as an exit structure consideration when the corporate property will eventually reach shareholders (where the double-tax on ordinary income at the corporate and individual levels is a significant drag on net proceeds).