Is Depreciation Recapture Ordinary Income?

The short answer

Partly. For real property like a rental building (Section 1250), recapture is not taxed at full ordinary income rates — it's "unrecaptured Section 1250 gain," capped at a maximum 25%. For personal property (Section 1245) — equipment, appliances, fixtures — recapture is taxed at ordinary income rates, which can be higher.

The distinction matters because it determines the rate applied to the portion of your gain that came from depreciation deductions.

Why recapture exists at all

Depreciation lowers your ordinary taxable income each year you hold the property. When you sell, the IRS "recaptures" some of that benefit. Congress chose a middle path for real estate: instead of clawing it all back at ordinary rates, it caps the depreciation portion at 25%.

Section 1250 vs. Section 1245

Section 1250 (buildings): recapture limited to depreciation taken, taxed at up to 25%.

Section 1245 (personal property and cost-segregated components): recapture taxed at ordinary income rates. This is why accelerating depreciation with a cost segregation study can convert some future recapture into higher-taxed 1245 recapture.

The terminology trap: three different things

Tax practitioners use "recapture" loosely, but three distinct concepts hide behind the word. True Section 1250 recapture is ordinary income, but it applies only to additional depreciation — depreciation claimed in excess of straight-line. Because real property placed in service after 1986 must be depreciated straight-line under MACRS, most modern rental buildings have zero additional depreciation and therefore zero true 1250 recapture.

Unrecaptured Section 1250 gain is the one that actually bites most sellers. It is the portion of your gain equal to the straight-line depreciation you took, and it is technically a capital gain taxed at a special maximum rate of 25% — not ordinary income, even though people loosely call it recapture. It is computed on the Unrecaptured Section 1250 Gain Worksheet in the Schedule D instructions.

Section 1245 recapture is the true ordinary-income clawback. It equals the lesser of the depreciation taken on the personal-property component or the gain on that component, and it is taxed at your marginal ordinary rate with no 25% cap. Getting these three straight is what separates an accurate estimate from a nasty April surprise.

A worked example: the two rates side by side

Suppose you bought a rental building for $400,000 (excluding land), depreciated it straight-line, and claimed $100,000 of depreciation over the years. Your adjusted basis is now $300,000. You sell for $500,000, producing a $200,000 total gain. Of that, $100,000 is unrecaptured Section 1250 gain taxed at up to 25% (a maximum of $25,000 in federal tax on that slice), and the remaining $100,000 is regular long-term capital gain taxed at 0%, 15%, or 20% depending on your income.

Now change one fact: instead of straight-line only, you had a cost segregation study reclassify $80,000 of the building into five-year personal property and took bonus depreciation on it. On sale, gain attributable to those Section 1245 assets — up to the depreciation claimed — is recaptured as ordinary income. For a high earner in the 35% bracket, that slice is taxed at 35% instead of 25%, a 10-percentage-point difference on that portion. The trade-off can still be worth it because you deducted at 35% up front and deferred the tax for years, but the character change is real and worth modeling before you sell.

The 25% figure is a ceiling, not a flat rate

Unrecaptured Section 1250 gain is taxed at your ordinary rate up to a maximum of 25%. If your ordinary marginal rate is 22%, the 1250 gain is taxed at 22%, not 25%. Only taxpayers whose ordinary rate exceeds 25% actually hit the cap. This surprises sellers who assume a flat 25% bill; middle-income sellers often pay less. The rest of your long-term gain is stacked on top and taxed at the separate 0/15/20% capital-gains schedule.

What stacks on top: NIIT and state tax

The 25% cap is a federal income-tax ceiling only. High earners may owe an additional 3.8% Net Investment Income Tax on the gain, pushing the effective federal rate on the 1250 slice toward 28.8%. Most states also tax the gain as ordinary income with no special recapture rate, so in a high-tax state the all-in rate on the depreciation portion can approach or exceed 35%. Always net these layers out before you assume a 25% hit.

How to report it on Form 4797

Sales of depreciable rental real estate are reported on Form 4797, Sales of Business Property. Section 1245 ordinary recapture is figured in Part III and carried to Part II as ordinary income. The long-term capital gain flows to Part I and then to Schedule D, where the Unrecaptured Section 1250 Gain Worksheet applies the 25% maximum rate. Keeping a clean depreciation schedule — ideally your cumulative Form 4562 filings — is what lets your preparer split the gain correctly.

Land improvements: a Section 1250 surprise

Not every shorter-life component is Section 1245. Land improvements — driveways, sidewalks, fences, landscaping, and parking lots — are 15-year property, yet they are classified as Section 1250 real property, not 1245 personal property. Historically these could be depreciated with the 150% declining-balance method, which produces depreciation in excess of straight-line. That excess is genuine additional depreciation subject to true Section 1250 ordinary-income recapture on sale — one of the few places a modern real estate investor actually encounters ordinary 1250 recapture rather than the 25%-capped unrecaptured gain. A cost segregation study that carves out land improvements should flag this so the character of the eventual gain is not a surprise.

Recapture survives a 1031 exchange

Deferring gain in a like-kind exchange does not change its character — it parks it. When you eventually sell replacement property without exchanging again, the deferred depreciation from every property in the chain resurfaces: unrecaptured Section 1250 gain is still taxed at up to 25%, and any Section 1245 component is still ordinary income. The exchange delays the day of reckoning; it does not convert ordinary recapture into capital gain. Only a step-up in basis at death permanently erases the accumulated recapture.

Recapture cannot create a capital loss

A subtle rule protects the government's recapture: the ordinary-income portion is recognized even if you sell the property at an overall loss for the personal-property component. Section 1245 recapture is the lesser of depreciation taken or gain, so it is capped by gain — but within a mixed sale, gain on 1245 assets is recaptured as ordinary income before any loss on other assets is netted. This is why allocating the sale price across the building, land, and personal property on the closing statement matters: the allocation drives how much falls into each recapture bucket.

Planning around the character of the gain

Because the two flavors of recapture are taxed so differently, timing and structure matter. Selling in a year when your ordinary bracket sits below 25% pulls the unrecaptured Section 1250 slice down with it — a sabbatical, early-retirement, or low-income year can meaningfully cut the effective rate. A 1031 exchange defers both characters of gain; an installment sale spreads the capital-gain slice across years but generally accelerates all depreciation recapture into the year of sale under Section 453(i), so recapture-heavy properties gain little from installment treatment. And harvesting capital losses elsewhere offsets the long-term capital-gain slice but not the ordinary Section 1245 recapture. Knowing which slice you are dealing with tells you which lever actually helps.

Why the distinction rewards good records

The line between 1250 and 1245 is only as reliable as your depreciation schedule. If a cost segregation study reclassified components years ago, you need that study and the annual Form 4562 filings to know how much gain is ordinary 1245 recapture versus 25%-capped 1250 gain. Without clean records, a preparer may default to treating the whole depreciation figure as unrecaptured 1250 gain — sometimes to your benefit, sometimes not — and an examiner may reach a different split. Keeping the original study, the placed-in-service dates, and the cumulative depreciation by asset class is what lets you report the character correctly and defend it.

Frequently asked questions

Sources

• IRS Topic No. 409 — Capital Gains and Losses
• IRS Publication 544 — Sales and Other Dispositions of Assets
• IRS Publication 946 — How to Depreciate Property

Educational information and estimates only. Not tax advice. Tax rules change and vary by situation; consult a qualified tax professional before acting.

Related

• Depreciation Recapture Calculator
• Unrecaptured Section 1250 Gain, Explained
• How to Avoid Depreciation Recapture