8.2 Business and Rental Property Dispositions: Section 1231, Depreciation Recapture (§1245 and §1250) & Form 4797

Why This Topic Matters

The outline item "Sale or disposition of property including depreciation recapture rules" reaches every individual who owns a rental property, a Schedule C business asset, or a farm asset. The preparer must identify the character of each dollar of gain because the pieces are taxed differently and reported in different parts of Form 4797 (Sales of Business Property).

Three Categories of Property

Section 1231 Netting

All Section 1231 gains and losses for the year (after recapture is pulled out) are netted:

• Net gain: Treated as long-term capital gain and carried to Schedule D, where it can qualify for the 0%, 15%, or 20% rates (or 25% to the extent of unrecaptured Section 1250 gain).
• Net loss: Treated as an ordinary loss, fully deductible against wages and other income, with no $3,000 capital loss limit.

This "best of both worlds" treatment is why Section 1231 matters: gains get capital rates, losses get ordinary deductions.

The 5-Year Lookback Rule (IRC §1231(c))

To stop taxpayers from bunching losses into one year (ordinary deductions) and gains into another (capital gain rates), a net Section 1231 gain is treated as ordinary income to the extent of nonrecaptured net Section 1231 losses from the five preceding years.

Example: In 2023, Nora deducted a $12,000 net Section 1231 loss as ordinary. In 2025 she has a $30,000 net Section 1231 gain. The first $12,000 of the 2025 gain is ordinary income; the remaining $18,000 is long-term capital gain. The 2023 loss is now fully recaptured and will not affect later years.

Section 1245 Recapture: Personal Property

Section 1245 property includes machinery, equipment, vehicles, furniture, and other depreciable personal property (and amortizable intangibles). On a sale, all depreciation allowed or allowable, including Section 179 expensing and bonus depreciation, is recaptured as ordinary income, but never more than the actual gain.

$\text{Section 1245 Ordinary Income} = \text{Lesser of (Gain Realized) or (Total Depreciation Taken)}$

Example: A sole proprietor bought equipment for $40,000 and claimed $28,000 of depreciation, leaving a $12,000 adjusted basis.

• Sold for $18,000: Gain is $6,000, all Section 1245 ordinary income (gain is less than depreciation).
• Sold for $45,000: Gain is $33,000: $28,000 Section 1245 ordinary income and $5,000 Section 1231 gain (the amount above original cost).
• Sold for $9,000: $3,000 loss, a Section 1231 ordinary loss (there is no recapture on a loss).

Recapture is not self-employment income, and it is recognized in full in the year of sale even on an installment sale.

Section 1250 Property and Unrecaptured Section 1250 Gain

Section 1250 property is depreciable real property: residential rental buildings, commercial buildings, and structural components.

• Section 1250 ordinary recapture applies only to additional depreciation (depreciation in excess of straight-line). Because MACRS requires straight-line for residential rental property (27.5 years) and nonresidential real property (39 years), individuals selling post-1986 buildings have no Section 1250 ordinary recapture.
• Unrecaptured Section 1250 gain: Gain equal to the straight-line depreciation claimed (or allowable) is taxed at a maximum 25% rate, computed on the Unrecaptured Section 1250 Gain Worksheet in the Schedule D instructions.
• Allowed or allowable: Basis is reduced by the depreciation the taxpayer was entitled to take, even if the taxpayer never claimed it, so skipping depreciation does not avoid the 25% tax. A taxpayer who never claimed depreciation can file Form 3115 to catch it up.

Example: Jamal bought a rental house in 2016; the building portion cost $275,000 and he has taken $85,000 of straight-line depreciation. In 2025 he sells for a price allocated $330,000 to the building and $80,000 to land (land cost $50,000).

1. Building: amount realized $330,000 - adjusted basis $190,000 = $140,000 of Section 1231 gain. Of that, $85,000 (the depreciation taken) is unrecaptured Section 1250 gain taxed at a maximum 25%, and $55,000 is taxed at regular long-term capital gain rates.
2. Land: $80,000 - $50,000 = $30,000 Section 1231 gain (land is not depreciable, so no recapture).
3. If Jamal has no other Section 1231 transactions and no lookback losses, his $170,000 net Section 1231 gain is long-term capital gain: $85,000 taxed at up to 25% and $85,000 ($55,000 + $30,000) at the 0%, 15%, or 20% rates. Any suspended passive losses from the rental are released in the year of this fully taxable sale.

Section 179 and Listed Property Recapture

If business use of listed property (such as a passenger vehicle) or of property expensed under Section 179 falls to 50% or less in a later year of the recovery period, the taxpayer must recapture as ordinary income the excess of the Section 179 or accelerated depreciation claimed over the straight-line depreciation that would have been allowed. This is reported on Form 4797, Part IV, and the basis is increased by the recaptured amount.

Related Parties and Other Special Rules

• IRC §1239: Gain on the sale of depreciable property between related parties (such as a taxpayer and a controlled entity) is ordinary income, not Section 1231 gain.
• Involuntary conversions: Casualty and theft gains and losses on business property held more than one year are first netted among themselves; a net casualty gain enters Section 1231 netting, while a net casualty loss is ordinary.
• Personal-use property is never Section 1231 property, and a loss on its sale is not deductible.
• Mixed-use property: When a separate part of a property (outside the home's living area, such as a detached rental unit) was used for business or rental, only that portion is reported on Form 4797; the residence portion goes on Form 8949 and may qualify for the Section 121 exclusion. A home office inside the dwelling unit needs no allocation, but gain equal to depreciation claimed after May 6, 1997 cannot be excluded.