Unrecaptured 1250 what does it mean?\I was transfered to a free tax person but the call disconnected

[TaxGuyBill · Accepted solution]

Unrecaptured Section 1250 Gain refers to the 'gain' (profit) when you sell real estate (Section 1250) and it was depreciated (unrecaptured).

So let's say that you sell real estate that had been depreciated.  The amount of depreciation that you took lowers the 'basis'.  In other words, if you bought the real estate for $100,000 and took $20,000 of depreciation on it, the 'basis' is now $80,000.  That $80,000 is used to determine your 'gain' (profit).

Let's say you sell the real estate for $150,000.  You have a 'gain' of $70,000 ($150,000 - $80,000).  Of that that $70,000 gain, $20,000 is because of the depreciation that you claimed.  That $20,000 is "Unrecaptured Section 1250 Gain".

The taxes are different for "Unrecaptured Section 1250 Gain" than regular long-term capital gain.  The Unrecaptured Section 1250 Gain is taxed at your regular tax bracket, up to a maximum of 25%.  Long-term capital gains are taxed at lower rates, usually 15%.

So in my example above, the $20,000 of Unrecaptured Section 1250 Gain would be regular tax rates (usually 25%) and the $50,000 would be taxed at long-term capital gain rates (usually 15%).

[cpasyed]

Note that section 1250 applies on the excess of the depreciation taken over the amount of the deprecation if the straight line depreciation method was used.

[marcisikoff]

Noting that with all Sec 1231 property (Sec 1245 or Sec 1250) a realized loss is treated as Ordinary Income loss (OI) and depreciation is not recaptured as part of that loss.

Responding to the poster above, Sec. 1250 refers to Sec. 1231 property that is real property such as buildings that has never been Sec. 1245 property.  What the poster referred to was that pre-1986 (I believe) you could have use a non-SL.  Since then you cannot.

Anecdotally, it's important to know that Unrecaptured Sec. 1250 gain was created to close a perceived loophole whereby sellers of Sec. 1250 property were gaining a depreciation expense advantage.

Example of Unrecaptured Sec 1250 Gain:

Taxpayer paid $27,500 for a rental property in 2010 and sold the property in 2020 for $50k

Easy math is 10 years of 1/27.5 of the cost = accumulated depreciation = $10k

Adjusted basis of the property = 27.5k - 10k = 17.5k

Realized gain on the sale = 50k - 17.5k = 32.5k (we're assuming on cost of sale for ease of example)

Of 32.5k, the first 10k will be unrecaptured Sec. 1250 gain, while 22.5k will be considered capital gains.

In this example if the taxpayer remained in a 18% effective tax rate throughout the duration of ownership, they achieved a tax benefit of $1,800 (18% of $10k) thru depreciation.  That also puts their taxable income ~60k if single.

Let's dig into the numbers:

If there's no other capital gains from equities, etc., then total Schedule D would report $32,500.

The Sch D tax calculation worksheet would show what is being taxed at 0/15/20 or 25% rates

0%: $2,500

15%: $20,000

20%: $0

25%: $10,000

28%: $0

That gives the total of $32,500 the correct taxation of $10k @ 25% (Unrecaptured Sec 1250) while the residual $22,500 is split between 0% and 15%.

Capital Gains tax would be: $5,500 (of which $2,500 was Unrecaptured Sec. 1250).

This is why I believe Sec. 1250 unrecaptured depreciation should be revised

1. Tax benefit of depreciation over 10 years: $1,800

2. Sec. 1250 unrecaptured depreciation: $2,500

3. Capital Gains cost of subtracting accumulated depreciation from purchase price to achieve adjusted basis: $1,125

Total benefit of depreciation to taxpayer: $1,800

Total cost of depreciation to taxpayer upon sale: $3,625

This taxpayer was penalized over 200% of their benefit because depreciation benefits are already eroded by lowering the basis, thus increasing capital gains at 0/15/20 tax rates and then compounding that with 25% of this eclipses any effective tax rates below 20%

Instead, Congress should change the code to allow for accumulated depreciation to have an accumulated benefit amount be used during the sale year and make sure that after calculating the capital gains, the smaller of the accumulated benefit and 25% of the accumulated depreciation should be Sec 1250 recapture.  Then although paying more capital gains because of the depreciation, at least the 1250 recapture would not exceed the gain from depreciation.

[MA111]

The instructions to Form 4797 states that Sec. 1250 recapture does not apply to certain dispositions of MACRS property acquired after 1986 including residential real estate.  So why is TurboTax applying the ordinary tax rate to this part of the gain?

[DaveF1006]

It depends. Does this apply to residential real estate? If so, it is suppose to be taxed at the capital gains rate. If you are working in Turbo Tax online, click on Live Tax Advice at the top of the page. Without being able to look at your tax forms, we cannot verify if you are being taxed at ordinary or capital gains rate.

[marcisikoff]

It would only apply to Residential Real estate if you had any cause to take depreciation on your home value, which would be the case in a year if you took a home office deduction.

Then to the extent of depreciation taken or allowed to be taken that income is treated as wage income (at your current tax rate, just like wages).  The residual of the net gain that is capital in nature hits at 0/15/20 based on your income.   If the net gain is smaller than the depreciation then all the gain becomes current tax rate.

[_Ciggy_]

These questions are specific to rental properties placed in service after 1987.  We assume a 27.5 year, straight line depreciation.   I believe @marcisikoff has a great suggestion and my questions might be related to his/her post.

1) Let's say you have limited income (with an income bracket of 12%).  When you sell your house and pay taxes on the recaptured depreciation, you get bumped up to at minimum a 22% income bracket (max 25%) because you had your rental for a long time and depreciated for many years.  So, you will pay 22-25% taxes on this recaptured depreciation.  **Is there any way to avoid this 22% rate? ** While you rent out the house, can you skip the yearly depreciation, pay your 12% income tax on your rental income profit, then somehow fill out form 3115 to help you avoid paying the 22-25% taxes on the depreciation at sale time?  

2) My friend has not been depreciating her rental house and asked me for advice.  Her house has been in the rental service for more than 5 years. To minimize having to deal with paying a tax expert multiple times, can she continue to NOT depreciate and when she goes to sell the house, deal with the mess only once, using Form 3115.  Notes, she is like me, we both live frugally in the 12% income bracket so there is NO benefit for her to depreciate right now from a tax perspective.  I do depreciate.

2b) How confusing is Form 3115 - is this impossible to figure out without a CPA? 

3) Capital Gains / 2 out of 5 year rule / Primary Residency question.  Are there any gotchas in terms of avoiding capital gains if you live in your rental in the following scenario: 2 years rental, 1 year primary, 1 year rental, 1 year primary?  As long as you do this correctly and your gain is less than $250K (single), you should not have to pay any capital gains, correct?  Yes, you will still have to pay taxes on the recaptured depreciation.

Thank you very much!  Happy New Year.