Understanding Depreciation Recapture: §1245 vs. §1250 Property
Introduction
Most real estate investors hear about depreciation as a huge tax benefit.
What doesn’t always get explained is what happens later…when you sell.
That’s where “recapture” comes in. And it’s tied to two parts of the tax code that sound complicated: §1245 and §1250 property.
That’s where “recapture” comes in. And it’s tied to two parts of the tax code that sound complicated: §1245 and §1250 property.
Making Sense of §1245 vs. §1250 Property
The terms “§1245” and “§1250” sound intimidating, but all they mean is different buckets in the tax code. The IRS likes to put assets into categories so they know how to treat them when you sell.
Think of it like this:
Think of it like this:
1. §1250 property = your building itself
- The walls, roof, foundation, and structure.
- The IRS says: “When you sell, the depreciation you claimed here gets taxed at a maximum of 25%.”
- So even if you’re in a higher tax bracket, this part is capped.
2. §1245 property = everything that’s inside or around the building that wears out faster
- Carpet, cabinets, lighting, electrical, HVAC components, parking lots, landscaping, etc.
- The IRS says: “All the depreciation you took here gets taxed back at your ordinary income rate (22%–37%).”
- No cap.
Here’s the key: a cost segregation study moves value out of the “building” bucket and into the “stuff inside and around it” bucket.
Why? Because the “stuff” wears out much faster than the building itself, which means you get to depreciate (write off) those costs faster.
Why? Because the “stuff” wears out much faster than the building itself, which means you get to depreciate (write off) those costs faster.
Why This Matters
Imagine you buy a $1M apartment building. If you do nothing, the IRS makes you depreciate the whole building over 27.5 years. That’s about $36K a year in write-offs.
But if you run a cost seg study, you might pull out $250K of items that really only last 5–15 years. Instead of waiting decades, you write those off right away.
That could mean close to $100K in tax savings in Year 1.
When you sell, yes, some of that gets “recaptured” as tax. But you controlled the timing—you got the savings upfront when you needed the cash.
But if you run a cost seg study, you might pull out $250K of items that really only last 5–15 years. Instead of waiting decades, you write those off right away.
That could mean close to $100K in tax savings in Year 1.
When you sell, yes, some of that gets “recaptured” as tax. But you controlled the timing—you got the savings upfront when you needed the cash.
The Impact of the Tax Code
So, the IRS isn’t giving you a free ride. They’re letting you take deductions early (on §1245 property), but they’ll want some of it back later if you sell.
The trick (and this is why savvy investors use cost segregation) is that you can often defer, reduce, or offset that recapture:
Here are the main strategies smart investors use:
The trick (and this is why savvy investors use cost segregation) is that you can often defer, reduce, or offset that recapture:
Here are the main strategies smart investors use:
1. 1031 Exchange
A 1031 lets you sell a property and roll all of your gain including depreciation recapture into a new property.
- You don’t pay tax today.
- The tax gets deferred until you sell without exchanging.
- Many investors keep “trading up” with 1031s and never recognize the recapture during their lifetime.
2. Buy More Real Estate
If you buy another property, the depreciation from that property can offset the income (and recapture) from your sale.
- This is the classic “snowball” strategy.
- You sell one deal, buy two more, and the fresh depreciation wipes out much of the gain.
3. Installment Sale
Instead of taking all the proceeds at once, you structure the sale so the buyer pays you over time.
- You only recognize part of the recapture each year as payments come in.
- This can keep you in a lower tax bracket and smooth out the impact.
4. Hold Longer
Even if you pay recapture later, the upfront savings have already worked in your favor.
- Example: Saving $100K today and investing it for 5–10 years often creates far more wealth than the $74K tax bill you’ll owe later.
- It’s the time value of money in action.
Case Study: $1M Property
Let’s look at a simple example.
Assumptions:
- Purchase price: $1,000,000
- Land: $200,000 → Depreciable basis: $800,000
- Sale after 5 years: $1,200,000
- Investor in 37% bracket
Without Cost Seg (straight-line only)
- 5 years of depreciation: $145,455
- Year 1 tax savings at 37%: $10,764
- Recapture tax at sale (25% cap): $36,364
With Cost Seg
- $250,000 reclassified as §1245 (accelerated in Year 1)
- 5 years of depreciation: $350,000
- Year 1 tax savings at 37%: $99,900
- Recapture tax at sale: $74,000 (all ordinary income from §1245)
The Difference
- Year 1 benefit: ~$100K in tax savings vs. ~$11K without.
- Extra recapture later: ~$74K vs. ~$36K.
- Net: the investor controlled ~$90K of cash years earlier which is money that could be reinvested or used to grow their portfolio.
Key Takeaways
- §1250 property is your building—recapture capped at 25%.
- §1245 property is the stuff inside and around it—recapture at ordinary income rates.
- Cost segregation shifts more into §1245, creating bigger upfront savings.
- With the right planning (1031s, new acquisitions, installment sales, longer holds), you can manage recapture effectively.
Cost segregation isn’t about avoiding taxes forever. It’s about accelerating deductions into the years when you need the cash most and making smart moves so that recapture doesn’t catch you off guard later.
About the Author
Sean Graham, CPA specializes in cost segregation, tax depreciation, and real estate tax savings. As the Chief Technical CPA at Maven Cost Segregation: Tax Advisors, he has overseen 1000+ cost segregation studies, helping investors maximize deductions.