Capital Gains Tax on Commercial Property

Thirty-nine years of straight-line depreciation builds a recapture layer that is capped at 25%

Section 168(c) assigns nonresidential real property a 39-year recovery period, straight line with a mid-month convention; a building earns the 27.5-year residential period only if 80% or more of its gross rents come from dwelling units. Because the method is straight line, section 1250(b)(1) finds no additional depreciation to recapture as ordinary income on the structure itself.

Instead, section 1(h)(6) sweeps the whole of that straight-line depreciation into unrecaptured section 1250 gain, taxed under section 1(h)(1)(E) at ordinary rates up to a 25% ceiling. On a building bought twelve years ago for $1,500,000 excluding land, that layer is about $460,000 before a dollar of appreciation is counted. The capital gains tax on rental property page shows how the layer stacks on other income.

Cost segregation and bonus depreciation turn part of the gain into ordinary income under sections 1245 and 1250

Most commercial owners have accelerated something. Fixtures, equipment and other personal property carved out by a cost segregation study are section 1245 property, and section 1245(a)(1) treats gain up to the depreciation taken on them as ordinary income at rates up to 37%, with no 25% ceiling. Under the Form 4797 instructions, section 1245 property also includes tangible real property other than buildings and structural components used as an integral part of manufacturing, production or extraction.

Improvements that are real property but were expensed with bonus depreciation, such as 15-year qualified improvement property or paving, are section 1250 property, and the instructions state that section 1250 recapture applies if you claimed any special depreciation allowance: the excess over straight line is additional depreciation taxed as ordinary income, and the straight-line part joins the 25% layer. Cost segregation and 1031 strategy and bonus depreciation on replacement property cover the planning.

The entity holding title changes the rate: pass-throughs keep the individual schedule, a C corporation pays 21% on everything

A partnership, LLC or S corporation passes each layer through to its owners, who apply the 2026 bands from Rev. Proc. 2025-32: 15% to $613,700 joint and $545,500 single, 20% above, 25% ceiling on the 1250 layer, and 3.8% NIIT under section 1411 above $250,000 joint or $200,000 single. A trust or estate reaches 20% at $16,250.

A C corporation has no preferential rate: section 11(b) taxes all of its income at 21%, and section 291(a)(1) treats 20% of the amount that would have been ordinary income had the building been section 1245 property as ordinary income under section 1250, which matters for capital loss netting rather than the rate. Getting the cash out to shareholders is a second tax. Can an LLC do a 1031 exchange and 1031 for S and C corporations cover the entity paths.

Worked example: a $3,000,000 office sale by a married couple in 2026

Hypothetical, round figures. A couple bought an office building twelve years ago for $2,000,000: $500,000 land, $1,350,000 building and $150,000 of cost-segregated fixtures that were fully expensed. Building depreciation to date is about $415,000. They sell for $3,000,000 with $150,000 of selling costs. Amount realized $2,850,000, adjusted basis $1,435,000, gain $1,415,000, split into $150,000 of section 1245 ordinary income, $415,000 of unrecaptured section 1250 gain and $850,000 of capital gain. Other taxable income is $300,000.

The $150,000 ordinary layer stacks from $300,000: $103,550 at 24% to the $403,550 bracket line is $24,852, and $46,450 at 32% is $14,864, so $39,716. The $415,000 depreciation layer would otherwise sit in the 32% and 35% brackets, so the 25% ceiling binds in full: $103,750. The $850,000 capital gain stacks from $865,000, entirely above $613,700, so 20%: $170,000. NIIT is 3.8% of the full $1,415,000 of net investment income because MAGI far exceeds $250,000: $53,770. Federal total $367,336, about 26% of the gain, before state tax.

Inside a C corporation the same gain would be taxed at 21%, $297,150, with a dividend tax still to come. Through an exchange, the $415,000 and $850,000 layers are deferred in full, and only the section 1245 layer needs separate handling. Run your own numbers with your CPA.

Where an exchange changes the outcome, and what the section 1245 components cost you

Section 1031 defers the gain on real property exchanged for real property, and section 1250(d)(4) limits the recapture taken into account to the gain recognized. Section 1245(b)(4) is narrower: recapture on section 1245 property is limited to the gain recognized plus the fair market value of property received that is not section 1245 property, so cost-segregated components exchanged into a building with no matching components can trigger their recapture even in an otherwise full exchange. That is a modelling item for the CPA before closing, not after.

Replacement options for a commercial seller include another building, a single-tenant NNN property, or an interest in a traditional DST; a cash out DST suits an owner who wants liquidity without a taxable sale. 1031 exit from small commercial walks a smaller owner through the same decision.