Section 1250 — Recapture Rules for Real Estate
Prior to 1986 for residential and 1981 for non-residential real property, the Tax Code was the real estate industry´s best friend. With accelerated depreciation and unlimited use of rental losses to offset other ordinary income, you could have vacancy factors of 50% or more and still make an after-tax profit.
The Tax Reform Act of 1986 changed all that, with disastrous effects on real estate prices. Here in Texas, the 1986 law coincided with depressed oil prices, and real estate values plummeted — in many cases to half or less of their pre-1986 levels.
If you acquire a real property today, you can use only straight-line depreciation, as opposed to accelerated depreciation; and the recovery periods are long — 27.5 years for residential and 39 years for non-residential. [You can, however, use cost segregation to depreciate certain building components over 3, 5, or 7 year recovery periods, using accelerated depreciation — I will cover cost segregation in a later blog entry]
Section 1250 was originally introduced in the pre-1986 days when real estate owners enjoyed the benefits of accelerated cost recovery. The reasons for section 1250 were the same as those for section 1245 (See August 7 blog entry). The rules require gains on real estate to be classified as ordinary income, to the extent of depreciation taken in excess of straight line. Since straight-line depreciation has been the only form of depreciation allowed since 1986, the recapture rules only apply to real estate placed in service before 1986, under the old ACRS rules (for commercial real estate, section 1250 recapture applies to property placed in service prior to 1981). These basic rules are fairly easy to understand and do no effect all that many properties being depreciated in 2006.
But wait, there´s more: "Unrecaptured" section 1250 gains — that is, gains on real estate due to straight line depreciation — have their own tax rates of 25% or 15% (depending on the owner´s tax bracket) rather than the 5%-15% capital gains rates. It´s important to remember that these special tax rates do not apply to gains due solely to a property´s increase in value — they apply only to gains that result from depreciation. You never have to worry about the section 1250 rules when only land is involved, because land cannot be depreciated.
Here´s an example:
In 2006 Susan sells her home for $150,000. She bought the house for $100,000 four years ago and has taken depreciation deductions of $2885 for ¼ of the house used as an office (this would make the office portion of Susan´s home non-residential real property). Susan has a gain of $52,885 (her adjusted basis is $100,000 - $2885 = $97,115). None of the gain is subject to section 1250 recapture, because the property was placed in service after 1981. But $2885 is an unrecaptured section 1250 gain. If Susan is in the 28% tax bracket, her tax rate for the $2885 gain will be $721.25 (25% of $2885). The remainder of Susan´s gain is excludable, because the house was Susan´s principal residence.
