Section 1245 Recapture on Real Estate: Cost Segregation and Land Improvements

Section 1245 property is depreciable property other than a building, and gain on it is ordinary income up to the depreciation taken

Section 1245(a)(1) says that when section 1245 property is sold, the amount by which the lower of its recomputed basis or the amount realized exceeds its adjusted basis is ordinary income, notwithstanding any other provision of the Code. Recomputed basis is adjusted basis plus every depreciation or amortization adjustment reflected in it, so in practice the ordinary income is the lesser of two numbers: the depreciation allowed or allowable on that asset, and the gain realized on that asset. Publication 544 states the test exactly that way.

The definition in section 1245(a)(3) covers personal property, plus other tangible property that is not a building or a structural component when it was used as an integral part of manufacturing, production, extraction, or furnishing transportation, communications, electrical energy, gas, water or sewage services, or as a research or storage facility for those activities. Reg. section 1.1245-3 borrows the investment credit definition of tangible personal property from Reg. section 1.48-1, which is why decades-old investment credit cases still decide what counts.

A building and its structural components are never section 1245 property. Depreciable real property that is not section 1245 property is section 1250 property under section 1250(c), and its recapture rules are gentler: only depreciation in excess of straight line is ordinary income, and post-1986 buildings are straight line, which leaves unrecaptured section 1250 gain taxed at a 25% maximum under section 1(h). The whole point of this page is the gap between those two characters.

Cost segregation exists to move building cost into section 1245 classes, so it changes the recapture character of that cost

In Hospital Corporation of America v. Commissioner, 109 T.C. 21 (1997), the Tax Court held that the tests developed under the old investment credit for separating tangible personal property from buildings still apply when classifying property under MACRS, and that the ban on component depreciation in section 168 reaches only section 1250 property. The IRS acquiesced to that use of the investment credit rules, as its Cost Segregation Audit Techniques Guide records; the guide is the examiner's playbook for these studies.

A study therefore walks a building looking for items that pass the tangible personal property tests, including the six Whiteco factors on permanence: how the item is attached, whether it can be moved and how often, what moving it does to the building, and whether it can be reused. Items that pass are reclassified from 27.5-year or 39-year property to 5-year or 7-year classes and become section 1245 property. Land improvements such as sidewalks, roads, fences and landscaping shrubbery fall into asset class 00.3 with a 15-year recovery period.

The guide is careful to say that asset class 00.3 includes land improvements whether they are section 1245 or section 1250 property. For a rental building, a parking lot is section 1250 property because it is not used as an integral part of manufacturing or a utility service; the same lot at a factory can be section 1245 property. How that distinction plays out at sale is covered on the land improvements depreciation page.

Since the July 2025 tax act restored a 100% first-year allowance for qualified property acquired and placed in service after January 19, 2025, Publication 946 confirms that the reclassified 5, 7 and 15-year classes can be written off at once. The deduction is real; so is the recapture character that comes with it.

At sale the ordinary income is measured asset by asset, so the price allocation decides how much is recaptured

Publication 544 requires a seller who disposes of more than one asset in a single transaction to figure the gain on each asset separately by allocating the selling price among them. Each section 1245 asset then produces ordinary income equal to the lesser of its own depreciation and its own gain. Components that have genuinely worn out may carry very little of the price, which caps the ordinary income on them at that small gain rather than at the full depreciation.

Hypothetical, round numbers: you bought an apartment building for $2,000,000 in 2022 and a study moved $300,000 into 5, 7 and 15-year property that has since been fully depreciated. In 2026 you sell for $2,600,000 and the contract allocates $200,000 to those components. Section 1245 ordinary income is $200,000, the lesser of $300,000 of depreciation and $200,000 of gain on the components. The rest of the gain belongs to the building and land: the straight-line building depreciation is unrecaptured section 1250 gain capped at 25%, and the remaining appreciation is long-term capital gain.

Had the allocation put $300,000 on the components instead, the ordinary income would have been $300,000. The allocation has to be defensible, and the buyer usually wants the opposite answer, but it is negotiated, not automatic. Run your own numbers with your CPA before the contract is signed.

Report the section 1245 and section 1250 computations in Part III of Form 4797, line 25 and line 26 respectively, per the Instructions for Form 4797. The ordinary portion flows to Part II; the rest goes through section 1231 and on to Schedule D, as the page on boot, recapture, Form 4797 and Schedule D shows line by line.

The installment method cannot spread section 1245 income, and 2026 ordinary rates make the character expensive

Section 453(i) requires any recapture income to be recognized in the year of disposition, and defines recapture income as the amount that would be ordinary under section 1245 or 1250 if every payment were received that year. Carrying a note for the buyer spreads the capital gain, but all of the section 1245 income lands in the sale year, which is also what Publication 544 says in plain words: it applies even if no payments are received that year. The 1031 versus installment sale guide walks through the rest of that choice.

For 2026, Rev. Proc. 2025-32 puts the 35% bracket at taxable income from $512,450 to $768,700 for joint filers, with 37% above that, and from $256,225 to $640,600 for single filers. A $300,000 recapture layer stacked on top of other income can therefore be taxed at 35% or 37%, against the 25% cap on building depreciation. The 3.8% net investment income tax applies to both layers for a passive owner, at thresholds of $250,000 joint and $200,000 single that are not indexed.

That rate gap, not the depreciation itself, is why the character matters. A seller who deducted reclassified components in a 32% year and recaptures them in a 37% year has borrowed at a negative spread; one who deducted at 37% and sells in a low-income retirement year has done the opposite. The cost segregation before selling page is built around that timing question.

A 1031 exchange defers section 1245 recapture only to the extent the replacement holds section 1245 property

Section 1245(b)(4) limits the recapture on a like-kind exchange to the sum of the gain otherwise recognized plus the fair market value of property acquired that is not section 1245 property. Reg. section 1.1245-4(d) applies the same formula, and Publication 544 gives the example: a seller gives up property with $10,000 of fully depreciated section 1245 components, receives only real property worth $100,000 and no cash, recognizes no gain under section 1031, and still reports the $10,000 as ordinary income because the section 1250 property received is worth more than that. The other $40,000 of gain stays deferred.

The 2020 regulations defining real property for section 1031 do not help here. Reg. section 1.1031(a)-3(a)(7) says its definitions apply only for section 1031 and that no inference is intended for depreciation or sections 1245 and 1250. A fixture can be real property for the exchange and section 1245 property for recapture at the same time.

The practical result for a seller who took a cost segregation study: exchanging into a replacement that holds mostly building, which describes most DSTs and most single properties, usually recognizes the section 1245 layer in the exchange year. The layer is deferred only if the replacement itself carries section 1245 property of at least that value, which a study on the replacement can support, as the page on bonus depreciation and cost segregation on replacement property explains. Section 1250 works differently: under section 1250(d)(4) its ordinary layer is recognized only to the extent additional depreciation exceeds the value of section 1250 property received, so it is almost always deferred, as covered in does a 1031 exchange defer depreciation recapture.

Recapture that is not recognized in the exchange does not disappear; Publication 544 says it attaches to the property acquired and is recognized when that property is sold at a gain. Model the exchange with the section 1245 schedule in hand, allocate the replacement purchase price with the same care, and expect the exchange-year return to show some ordinary income if the replacement is a conventional building or a traditional DST.