What is Section 1250?
According to Section 1250 of the U.S. Internal Revenue Code, if the total depreciation exceeds the depreciation determined using the straight-line approach, the IRS will tax any gain on the sale of depreciated real estate as ordinary income.
The amount of tax owed is determined under Section 1250 based on the kind of property, namely whether it is residential or nonresidential real estate, as well as the number of months the filer possessed the property in issue.
The Basics of Section 1250
Gains from the sale of depreciable real estate, such as commercial buildings, warehouses, barns, rental properties, and their structural components, are subject to regular taxation under Section 1250. However, this tax rule does not apply to land area or personal physical or intangible possessions.
When a business uses the accelerated depreciation method to depreciate its real estate, which produces higher deductions in the early life of a tangible asset, then the straight-line approach is primarily relevant. According to Section 1250, the IRS taxes the difference between the actual depreciation and the straight-line depreciation as ordinary income if a real estate owner uses the accelerated depreciation method and the property sells for a purchase price that results in a taxable gain.
The IRS requires all real estate acquired after 1986 to be depreciated using the straight-line method. Therefore, it is unusual for profits to be treated as regular income under Section 1250. There are no potential taxable profits if the property is sold as part of a like-kind exchange, given as a gift upon death, or disposed of in another way by the owner.
An Illustration of How Section 1250 Is Used
Consider the following scenario to see a practical use: an investor purchases an $800,000 piece of real estate with a 40-year useful life. Using the accelerated depreciation approach, this investor claims $120,000 in cumulative depreciation charges five years later for a $680,000 cost basis.
Assume that this investor sells the property for $750,000, generating a total taxable gain of $70,000. Because the $800,000 initial price divided by 40 years and multiplied by five years of use equals $100,000 in accumulated straight-line depreciation, the Internal Revenue Service must tax $20,000 of the actual depreciation that exceeds straight-line depreciation as ordinary income. The remaining $50,000 of the total gain would then be subject to capital gains taxation at the appropriate rates by the IRS.
The actual gain reported on a real estate transaction may only be recovered as regular income under Section 1250. In our scenario, the Internal Revenue Service would only classify $10,000 of the $10,000 profit the investor would have made if they had sold the real estate for $690,000 as ordinary income, not the extra $20,000.
Conclusion
- According to Section 1250 of the U.S. Internal Revenue Code, if the total depreciation exceeds the depreciation determined using the straight-line approach, the IRS will tax any gain on the sale of depreciated real property as ordinary income.
- When a business uses the accelerated depreciation method to depreciate its real estate, Section 1250 is primarily relevant.
