Section 1231 property is typically business or trade real estate, so unrecaptured Section 1250 gains usually only come into play for non-business owners if they have rental property. Let’s say you purchased a rental property for $200,000 in 2020. You’re entitled to depreciate it over five years. That works out to $40,000 per year: $200,000 divided by five. You claim $80,000 in depreciation in 2020 and 2021. This brings your cost basis down to $120,000 ($200,000 minus $80,000) in claimed depreciation. You sell the property for $250,000 in 2022. Under Section 1250 rules, you’ve realized a gain of $130,000 ($250,000 minus your $120,000 basis adjusted for depreciation), not $50,000 ($250,000 minus your $200,000 purchase price). The $80,000 you claimed as depreciation is recaptured and taxed at a maximum of 25%. Only the remaining $50,000 is taxed at the more favorable long-term capital gains tax rate of just 15%.
How an Unrecaptured Section 1250 Gain Works
Section 1250 tags the gain you get from selling property as “unrecaptured” when the sales price exceeds your initial cost basis in the asset, which is the total of what you paid for it and spent on maintaining it. It adjusts this basis by adding back the depreciation you claimed. An unrecaptured Section 1250 gain effectively prevents you from taking a double-dip tax break. It changes the rate at which realized gains are taxed with the intention of offsetting that depreciation you claimed. It prohibits you from claiming advantageous long-term capital gains rates on the entirety of your profit. But “offset” is the key word here in another respect. The IRC allows you to offset Section 1250 gains with Section 1231 capital losses, provided both assets were held for more than a year so both your loss and your gain are long term. This means you can subtract your loss from the amount of your gain, and pay tax on the difference.
How To Report Uncaptured Section 1250 Gains
You report uncaptured Section 1250 gains on Form 4797, then transfer that total to Schedule D. The instructions for Schedule D include detailed explanations and worksheets to help you make your calculations. Enter the resulting tax amount on line 16 of your Form 1040 tax return.
How Much Are Taxes on Unrecaptured Section 1250 Gains?
The tax on unrecaptured Section 1250 gains tops out at 25%, which is considerably higher than two of the three tax rates for long-term capital gains, which ranges from 0% to 20%, depending on your income. Most taxpayers pay a 0% or 15% rate on long-term capital gains, which is at least 10% less than the unrecaptured Section 1250 rate. The 25% rate applies to money received in the first through fourth years if you accepted installment payments after 1999. Some gains can be taxed at 20% after the first four years, but this is still higher than the long-term capital gains tax rate for most taxpayers.
