Unrecaptured section 1250 gain is the long-term gain on a sale of depreciable real property, up to the depreciation previously taken, that is not already ordinary income, taxed at a maximum federal rate of 25% for a noncorporate taxpayer under IRC §1(h)(1)(E), before the net investment income tax and state tax; cost segregation does not change that rate, but it changes how much depreciation lands in this layer instead of ordinary-income §1245 recapture.
A cost segregation study splits a building's cost into 5-, 7- and 15-year components and the 27.5- or 39-year structure. On a taxable sale at a gain, the structure's straight-line depreciation is unrecaptured §1250 gain, while the 5- and 7-year components are section 1245 property, whose depreciation is ordinary income up to the gain. This guide explains the two layers, the 25% ceiling, what cost segregation does to the mix, and how a 10-year Opportunity Zone hold with the §1400Z-2(c) election changes the result.
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What Is Unrecaptured Section 1250 Gain, Exactly?
Unrecaptured section 1250 gain is a defined term in IRC §1(h)(6): for a noncorporate taxpayer, it is the long-term capital gain from selling depreciable real property that comes from depreciation previously taken, limited to the gain actually realized and reduced by any net loss in the 28%-rate group (§1(h)(6)(A)(ii)). The statute defines it by reference to what would be ordinary income if every dollar of depreciation were recaptured:
"the amount of long-term capital gain (not otherwise treated as ordinary income) which would be treated as ordinary income if section 1250(b)(1) included all depreciation and the applicable percentage under section 1250(a) were 100 percent" IRC §1(h)(6)(A)(i)
It is called "unrecaptured" because IRC §1250(a) recaptures as ordinary income only "additional depreciation," and for real property held more than one year that means only depreciation above the straight-line amount (§1250(b)(1)). A 27.5-year or 39-year building is depreciated on the straight-line method, so, while the structure is depreciated straight-line, none of its depreciation is recaptured as ordinary income under §1250(a). Section 1(h) instead taxes that straight-line depreciation, on a sale at a gain, at a maximum rate of 25% (§1(h)(1)(E)), which is higher than the 15% and 20% rates on other long-term capital gain and lower than the top ordinary rate.
Two limits keep the definition from being overstated. The layer cannot exceed the gain on the sale, so a sale at or below adjusted basis produces none. And for sales of business property treated under IRC §1231, the amount in any tax year cannot exceed net §1231 gain for that year (§1(h)(6)(B)). The 25% rate is a noncorporate rate; a C corporation does not use it.
How Does Unrecaptured Section 1250 Gain Differ From Section 1245 Gain on a Cost-Segregated Building?
On a building that has had a cost segregation study, a sale at a gain is taxed in layers by the kind of property, and only the real-property layers are unrecaptured §1250 gain. On a taxable sale at a gain, recapture applies, up to the amount of that gain, however long the property was held, outside the Opportunity Zone 10-year rule (a qualifying investment held 10 years with the IRC §1400Z-2(c) election): §1245 recapture on the 5- and 7-year property is ordinary income, as is §1250 recapture of the depreciation taken above straight-line (bonus included) on 15-year land improvements held more than one year, and the rest of the depreciation on those land improvements and on the 27.5- or 39-year structure is unrecaptured §1250 gain, taxed at up to 25% for a noncorporate taxpayer.
- 5- and 7-year components. These are generally section 1245 property. The gain, up to the depreciation previously allowed or allowable on them, is ordinary income under IRC §1245(a)(1), however long they were held. Any gain above that depreciation is §1231 gain.
- 15-year land improvements. For an ordinary rental or commercial building these are §1250 property, not §1245 property (§1250(c)). Depreciation above straight-line, bonus depreciation included, is ordinary income under §1250(a) when the property was held more than one year, and the straight-line equivalent is unrecaptured §1250 gain.
- The 27.5- or 39-year structure. All of its depreciation is unrecaptured §1250 gain, up to the gain, because straight-line depreciation leaves no excess to recapture as ordinary income.
- Land. Land is not depreciated, so no part of the gain on land is unrecaptured §1250 gain.
Section 1245 and §1250 are separate recapture provisions applied property by property, which is why the sale price has to be allocated among land, structure, land improvements and the short-life components before any layer can be computed. The §1245 recapture exit strategy post covers the ordinary-income side and the net-present-value question in detail.
How Does Cost Segregation Change Your Unrecaptured Section 1250 Gain at Sale?
Cost segregation does not add depreciation or change the property's total cost; it moves part of the building's cost out of the 27.5- or 39-year structure and into shorter-life components, so on the same sale facts less of the depreciation is unrecaptured §1250 gain and more of it is ordinary-income §1245 recapture, up to the gain on those components. That shift is also the source of the earlier deductions: the same dollars are depreciated sooner, and recaptured at a possibly higher rate when the property is sold.
Hypothetical, not a forecast. A rental building has $1,000,000 of depreciable cost. Without a study, all of it is 39-year property. With a study, $200,000 is 5-year §1245 property and $800,000 stays 39-year property. Assume a sale after exactly 10 years of depreciation at a gain larger than all the depreciation, that the 5-year property is fully depreciated, that the sale price allocated to it is at least its original cost, and a top individual rate of 37% on ordinary income; ignore the mid-month convention and the net investment income tax.
- Without a study: ten years of straight-line depreciation on $1,000,000 over 39 years is about $256,000, all unrecaptured §1250 gain, taxed at up to 25%, or up to about $64,000.
- With a study: the $200,000 of 5-year depreciation is §1245 ordinary income, taxed at up to 37%, or up to $74,000; ten years of straight-line depreciation on the remaining $800,000 is about $205,000 of unrecaptured §1250 gain, taxed at up to 25%, or up to about $51,000.
In this hypothetical the study shrinks the unrecaptured §1250 layer by about $51,000 of gain and adds a $200,000 ordinary-income layer. The study also moved $200,000 of deductions into the first five years instead of spreading them over 39, so whether the earlier deductions are worth more than the larger ordinary-income layer at sale depends on the rate when the deductions were used, the rate at sale and how long the property is held. A short hold narrows the advantage because the recapture arrives before the time value of the earlier deductions accumulates.
How Is Unrecaptured Section 1250 Gain Computed and Reported?
Unrecaptured section 1250 gain is computed property by property after the amount realized is allocated, and it is reported on Form 4797 and carried to line 19 of Schedule D through the Unrecaptured Section 1250 Gain Worksheet in the Schedule D instructions. The order is:
- Allocate the amount realized among the land, the structure, the land improvements and each §1245 component.
- Subtract each component's adjusted basis to get its gain.
- Treat the gain on each §1245 component, up to the depreciation allowed or allowable on it, as ordinary income.
- Treat depreciation on §1250 property above straight-line as ordinary income, then treat the remaining depreciation on that property, up to its remaining gain, as unrecaptured §1250 gain.
- Tax the rest of the gain as long-term capital gain or §1231 gain, if the property was held more than one year.
The 25% is a maximum. Under the §1(h)(1)(E) formula, the part of the layer that falls where the ordinary rate for that income is below 25% is taxed at that lower rate.
Does a 10-Year Opportunity Zone Hold Change Unrecaptured Section 1250 Gain?
A 10-year Opportunity Zone hold with the §1400Z-2(c) election can remove unrecaptured §1250 gain on a sale of the fund interest and, for a partnership or S-corporation fund, on a fund-level sale of the property under a separate election; neither applies before year 10. On a taxable sale before year 10, recapture behaves normally: §1245 recapture on the 5- and 7-year property is ordinary income, as is §1250 recapture of the depreciation taken above straight-line (bonus included) on 15-year land improvements held more than one year, and the rest of the depreciation on those land improvements and on the 27.5- or 39-year structure is unrecaptured §1250 gain, taxed at up to 25% for a noncorporate taxpayer. Nothing about Opportunity Zone status shields that.
On a qualifying investment held 10 years, an investor who elected deferral and sells the interest in a Qualified Opportunity Fund taxed as a partnership may elect to step basis to fair market value under IRC §1400Z-2(c), and on that sale the election removes both the ordinary recapture and the unrecaptured §1250 gain, which is what converts cost segregation from a timing benefit into a permanent one.
If the fund sells the property, a separate election under Treas. Reg. §1.1400Z2(c)-1(b)(2)(ii) can exclude the gain for partnership or S-corporation funds, and a corporate fund gets no such election. Under §1400Z-2(c), the election sets the investor's basis in the qualifying investment to its fair market value when the investment is sold or exchanged, which is why the form of the sale decides which gain the election reaches. A cost segregation study during the hold front-loads the deductions, and the election is what can turn that timing benefit into a permanent one. The Opportunity Zone cost segregation guide works through the whole hold, and two companion posts cover what happens to cost segregation deductions on a sale before year 10 and the 10-year exclusion when the fund sells the property.
To see how a study would split your own building's cost, the cost segregation qualifier is the first step, and how cost segregation firms compare covers who models the exit alongside the deduction. For the layer on the other side of this one, read what section 1245 property is. The series hub, the three layers of gain when you sell, ties the layers together.
Frequently Asked Questions
What is the tax rate on unrecaptured section 1250 gain from depreciation?
The rate is up to 25% for a noncorporate taxpayer under IRC §1(h)(1)(E), on long-term gain from depreciable real property held more than one year. Part of it is taxed at the ordinary rate for that income when that rate is below 25%, and a C corporation does not use the 25% rate. The rate is a federal income tax rate, before the 3.8% net investment income tax and state tax.
Is unrecaptured section 1250 gain the same as depreciation recapture?
Not in the statutory sense: "recapture" in IRC §1245 and §1250(a) means gain taxed as ordinary income, while unrecaptured section 1250 gain is long-term capital gain taxed at up to 25%. Practitioners often call it recapture because it is gain attributable to depreciation, and because it is taxed at a higher maximum than other long-term capital gain.
Does cost segregation increase unrecaptured section 1250 gain?
Cost segregation does not increase it, because a study does not add depreciation; it moves part of the building's cost into 5-, 7- and 15-year components. On the same sale facts, less of the depreciation is then unrecaptured §1250 gain and more is §1245 ordinary income, up to the gain on those components.
Does unrecaptured section 1250 gain apply to land, which is not depreciated?
Land produces none, because land is not depreciable, so no depreciation exists to be taxed in this layer. Gain on land is taxed as capital or §1231 gain, depending on how the land was held.
Can unrecaptured section 1250 gain be deferred or avoided at sale?
It can be deferred by a like-kind exchange of real property under IRC §1031(a), which defers the gain rather than eliminating it, and the basis step-up under IRC §1014 for property an heir acquires from a decedent can eliminate the gain inherent in the property, subject to that section's exceptions. For an investor who elected deferral and holds a Qualified Opportunity Fund interest for 10 years, the §1400Z-2(c) election can remove it on a sale of the interest in a fund taxed as a partnership, and a separate election under Treas. Reg. §1.1400Z2(c)-1(b)(2)(ii) can exclude it on the fund's own sale of the property for a partnership or S-corporation fund; neither applies to a sale before year 10.
Does the 25% rate apply to a building I held for less than a year?
It does not, because the layer is defined as long-term capital gain, which requires a holding period of more than one year. Gain on property held one year or less is short-term, and depreciation recapture under IRC §1245 is ordinary income however long the property was held.
