26.2 Depreciation Recapture and Unrecaptured Gain

Why Recapture Changes the Answer

Cost recovery gives a taxpayer ordinary deductions while an asset is used in business. When the asset is sold, the tax law asks whether part of the gain is really a recovery of those prior depreciation deductions. That is depreciation recapture: it prevents deducting depreciation against ordinary income and then receiving long-term capital gain treatment on the same economic dollars.

The 2026 TCP Blueprint specifically lists calculating Section 1245 recapture, Section 1250 recapture, and unrecaptured Section 1250 gain on dispositions of trade-or-business assets. The topic loops back to REG because a wrong depreciation schedule produces a wrong adjusted basis, which produces a wrong recapture number and a wrong character.

The Recapture Table

Section 1245 — Personal Property

Section 1245 property is depreciable tangible personal property used in business plus certain amortizable intangibles. The rule is blunt: ordinary recapture equals the lesser of total realized gain or depreciation allowed/allowable.

Worked example: a machine cost $100,000, accumulated depreciation is $70,000, so adjusted basis is $30,000. Sold for $80,000, total gain is $50,000. Because depreciation taken ($70,000) exceeds the gain ($50,000), ALL $50,000 is ordinary Section 1245 recapture and there is no residual Section 1231 gain.

Now change the sale price to $120,000. Gain is $90,000. Recapture is the lesser of $90,000 or $70,000, so $70,000 is ordinary and the remaining $20,000 (gain above original cost) is Section 1231 gain. Losses are different: recapture never turns a loss into income. A sale below adjusted basis runs through Section 1231 if the holding-period and business-use tests are met.

Section 1250 and Unrecaptured Section 1250 Gain

Section 1250 property is depreciable real property — a business building or rental building. Ordinary Section 1250 recapture applies only to excess depreciation (accelerated minus straight-line). Because modern real property uses MACRS straight-line (27.5 years residential, 39 years nonresidential), most exam buildings generate zero ordinary Section 1250 recapture.

The depreciation is not ignored, though. Gain attributable to straight-line depreciation becomes unrecaptured Section 1250 gain — still a long-term capital gain, but separated because it is taxed at a maximum federal rate of 25% (verified 2026), higher than the regular 0/15/20% rates but below ordinary rates. The exam normally supplies the depreciation amount; do not import indexed bracket thresholds from memory.

Recapture Workflow

For every disposition, build the calculation in this order:

1. Compute amount realized.
2. Compute adjusted basis using depreciation allowed or allowable.
3. Determine total realized gain or loss.
4. Classify the asset: Section 1245, Section 1250, or other.
5. Calculate ordinary recapture FIRST.
6. Classify the residual gain as Section 1231 or capital, then net.
7. For installment sales, recognize ALL recapture in the year of sale before applying installment deferral to the remaining gain.

Simulation Review Points

In a task-based simulation, tie the fixed-asset register to invoices, depreciation schedules, and the sale document. Check placed-in-service dates, accumulated depreciation, business-use percentage, and whether the draft return reports business-asset sales on Form 4797 Part III (recapture) rather than Schedule D. If a diagnostic flags a disposition but the draft shows plain capital gain, suspect that recapture was skipped.

Allowed-or-Allowable: A Recurring Exam Hook

Adjusted basis is reduced by depreciation allowed or allowable, a phrase the examiners love to test. If a taxpayer was entitled to $10,000 of depreciation but only claimed $6,000, basis is still reduced by the full $10,000 (the allowable amount), and recapture is measured on that larger reduction. The taxpayer effectively loses the unclaimed $4,000 deduction yet still pays recapture on it — a harsh but tested rule. The fix is to file an accounting-method change rather than amend, but the exam point is simply that you never reduce the basis adjustment just because the return understated depreciation.

Putting Recapture and Section 1231 Together

Consider a fuller scenario. A company sells three Section 1231 assets in one year: a machine (Section 1245) with a $50,000 gain, of which $40,000 is depreciation recapture; a warehouse (Section 1250, straight-line) with a $30,000 gain, all unrecaptured Section 1250 gain; and land with a $20,000 loss. First, carve out the $40,000 of ordinary Section 1245 recapture — it leaves the Section 1231 process entirely as ordinary income. The residual amounts entering Section 1231 netting are the machine's remaining $10,000 gain, the warehouse's $30,000 gain, and the land's $20,000 loss, for a net Section 1231 gain of $20,000.

That $20,000 is long-term capital gain, but the $30,000 warehouse component keeps its unrecaptured-Section-1250 25% character within that capital-gain total. Finally, apply the five-year lookback: if the company reported, say, $8,000 of nonrecaptured net Section 1231 losses in the prior five years, $8,000 of the $20,000 net gain is recharacterized as ordinary income and only $12,000 stays long-term capital gain. This sequencing — recapture, then netting, then lookback — is exactly what a TCP simulation grades.