How the 25% Rate Works
When you sell real estate that has been depreciated, the IRS requires you to recapture the depreciation deductions you’ve taken over the years. However, instead of taxing the entire recaptured amount at ordinary income tax rates, the 25% depreciation recapture rate limits how much of this recapture is taxed at higher ordinary income rates.
This means that if you’ve claimed depreciation on a rental property, for example, the portion of your gain attributed to the depreciation will be taxed at a maximum rate of 25% rather than your normal income tax rate, which could be higher.
How Section 1250 Applies
Section 1250 of the tax code applies specifically to real property, such as commercial and residential rental buildings. This section limits the amount of depreciation recapture on real estate that can be taxed as ordinary income, instead imposing a maximum rate of 25%.
Example
If you bought a property for $200,000 and took $50,000 in depreciation deductions over time, when you sell the property for $250,000, you would have a $50,000 gain. The $50,000 depreciation portion of the gain would be taxed at 25%, while any remaining gain above the original purchase price would be taxed as capital gains.
Final Advice
Understanding the 25% depreciation recapture rule is crucial when selling real estate. It helps you plan for the potential tax impact and make informed decisions. Always consult with a tax professional to ensure you’re complying with the rules and minimizing your tax burden.
