Short answer: When an individual, directly or through a fund, sells a building at a gain, the part of the gain that comes from depreciation already deducted is called unrecaptured section 1250 gain. It is taxed at a maximum 25% federal rate, not the usual 20% long-term capital gains rate. The rest of the gain gets the normal capital gains rate. It shows up on a partnership K-1 in box 9c, on a REIT investor's Form 1099-DIV in box 2b, and in the sale of an interest in a real estate fund.

Why the rule exists

Buildings are depreciated: each year the owner deducts part of the cost against ordinary income, and the property's tax basis goes down by the same amount. When the building is sold, the lower basis makes the gain bigger. Without a special rule, the owner would deduct depreciation at ordinary rates of up to 37% and later pay only 20% on the gain that depreciation created.

For equipment and other section 1245 property, the tax code claws all of that back: gain up to the depreciation taken is ordinary income. For buildings, which are section 1250 property, Congress chose a middle path. Only depreciation taken faster than straight-line is recaptured as ordinary income. The rest of the depreciation-related gain is taxed at a capped rate of 25%. That capped slice is "unrecaptured" section 1250 gain: gain that section 1250 itself does not turn into ordinary income.

How it is measured

Unrecaptured section 1250 gain is the long-term gain that would be ordinary income if all depreciation on the building were recaptured, minus any part that is already ordinary. In practice, for a building depreciated on the straight-line method:

Unrecaptured section 1250 gain = the lower of (a) total depreciation taken and (b) the total gain on the sale.

Three points follow:

  • It cannot exceed the gain. If you sell for less than the original cost, the whole gain may fall into the 25% bucket, but never more than the gain itself.
  • Depreciation "allowed or allowable" counts. Basis is reduced by the depreciation you were entitled to, even if you did not claim it, so skipping deductions does not shrink the 25% slice.
  • Land is not depreciable. Only the building's depreciation feeds the calculation. Gain on the land is taxed at the normal long-term rate.

What counts as section 1250 property

Section 1250 property is depreciable real property that is not section 1245 property: buildings, their structural components, and most permanent improvements. Today, residential rental buildings are depreciated straight-line over 27.5 years and non-residential buildings over 39 years, so the ordinary-income "additional depreciation" recapture under section 1250 itself is usually zero, and all of the depreciation-related gain lands in the 25% bucket.

Two exceptions are common in fund-owned real estate:

  • Cost segregation. A cost segregation study reclassifies parts of a building, such as certain fixtures, dedicated equipment wiring and carpeting, into shorter-lived section 1245 property. Those parts depreciate faster, often with bonus depreciation, but on a sale the gain up to their depreciation is ordinary income, not 25% gain.
  • Bonus depreciation on real property improvements. Some section 1250 property, such as qualified improvement property, can qualify for bonus depreciation. The deduction above what straight-line would have allowed is generally "additional depreciation", which section 1250 recaptures as ordinary income. Only the straight-line portion feeds unrecaptured section 1250 gain.

Who pays the 25% rate

The 25% cap matters for individuals, trusts and estates. A C corporation pays a flat 21% on all its income, so the bucket makes no difference to a corporate seller. The 25% is a maximum: a taxpayer whose ordinary rate on that slice is lower pays the lower rate. The 3.8% net investment income tax can apply on top, for example to a passive investor in a real estate fund.

It also only applies to long-term gain, so the building must have been held for more than one year.

How it reaches fund investors

  • Partnerships and funds. A real estate fund or partnership that sells a building reports the unrecaptured section 1250 gain separately on Schedule K and each partner's Schedule K-1, in box 9c. The same amount is usually also included in the net section 1231 gain the K-1 reports, so it should not be counted twice.
  • Selling a fund interest. When an investor sells a partnership interest held for more than a year, the regulations apply a look-through rule: the investor's unrecaptured section 1250 gain includes the amount that would have been allocated to them if the partnership had sold all its section 1250 property at fair market value just before the sale. So selling the interest, rather than the buildings, does not escape the 25% rate.
  • REIT dividends. When a REIT sells property and pays out the gain as a capital gain dividend, it reports the part that is unrecaptured section 1250 gain in box 2b of Form 1099-DIV, and the investor taxes it at up to 25%.
  • Installment sales. If a building is sold for payments over several years, the unrecaptured section 1250 gain is taxed first, before the 20% gain, as payments come in.

The rule also interacts with the section 1231 netting rules. Gain on a building used in a business or held for rent is usually section 1231 gain, and the unrecaptured section 1250 amount from those sales cannot exceed the year's net section 1231 gain. If the seller had net section 1231 losses in the previous five years, part of the gain can be recharacterised as ordinary income first.

Worked example

An individual investor buys a small office building for $10 million: $2 million for the land and $8 million for the building. Over the years they deduct $2 million of straight-line depreciation, so their adjusted basis falls to $8 million. They sell for $14 million after more than a year, with no other section 1231 gains or losses.

  • Total gain: $14 million − $8 million = $6 million.
  • Unrecaptured section 1250 gain: the lower of depreciation taken ($2 million) and the gain ($6 million) = $2 million, taxed at up to 25%: $500,000.
  • The rest: $4 million of long-term gain at 20%: $800,000.
  • Total federal income tax: $1.3 million, compared with $1.2 million if all $6 million were taxed at 20%. The 3.8% net investment income tax, where it applies, would add $228,000.

If a cost segregation study had moved part of the building into five-year property, the gain up to that property's depreciation would be ordinary income at up to 37% instead.

What can defer it

A like-kind exchange under section 1031 defers the whole gain, including the unrecaptured section 1250 portion, by rolling it into the replacement property. The deferred depreciation travels with it and comes due when the replacement is eventually sold in a taxable sale. Gain avoided because property passes at death with a stepped-up basis is not taxed at all.

This explainer is general information, not tax advice.

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This explainer is analysis and general information, not tax, legal or investment advice.