Section 1245

Section 1245: Definition, Tax Treatment, and Example

Key takeaways

• Section 1245 of the Internal Revenue Code requires “recapture” of depreciation or amortization taken on certain business property when that property is sold at a gain.
• Depreciation recapture under Section 1245 is taxed as ordinary income to the extent of the allowable or allowed depreciation or amortization.
• Any remaining gain, after recapture, is treated under Section 1231 and may qualify for capital gains taxation.
• If the property is sold at a loss, it generally becomes a Section 1231 loss (treated as ordinary loss subject to netting rules).

What is Section 1245?

Section 1245 applies to gains from the sale or transfer of depreciable or amortizable business property that has been held for more than one year. It converts part or all of a recognized gain into ordinary income to the extent of depreciation or amortization that was taken (or could have been taken) on the asset.

What property qualifies as Section 1245 property?

Section 1245 property generally includes:
* Tangible personal property used in a business (equipment, machinery, vehicles), and
Intangible personal property that is amortizable (certain patents, copyrights, goodwill in some cases), and
Other tangible property used in production, transportation, communication, utilities, research facilities, or bulk storage of commodities—excluding buildings and their structural components.

A property is treated as Section 1245 property only while it has unrecaptured depreciation or amortization.

How recapture works

• “Allowed or allowable” depreciation/amortization is recaptured. That means recapture equals the greater of depreciation actually taken or depreciation that could have been taken.
• When the property is sold at a gain, the portion of gain equal to unrecaptured depreciation is taxed as ordinary income under Section 1245.
• Any gain in excess of the recaptured amount is treated as Section 1231 gain and, if net Section 1231 rules apply, may qualify for capital gains rates.
• If the property is sold at a loss, Section 1245 does not produce recapture; the loss is treated under Section 1231 rules (typically ordinary loss after netting and lookback rules).

Example

A business buys equipment for $100 and takes $75 of depreciation. The adjusted tax basis is $25.
* If the equipment sells for $150: total gain = $150 − $25 = $125.
* $75 of that gain (the depreciation taken) is Section 1245 recapture taxed as ordinary income.
* The remaining $50 is Section 1231 gain and may be eligible for capital gains treatment.
* If the equipment sells for $20: loss = $20 − $25 = $5. Section 1245 does not apply and the $5 loss is a Section 1231 loss.

Relationship to Section 1231

Section 1231 defines tax treatment for sales of depreciable business property held more than one year. Section 1245 is effectively a subset that strips out prior depreciation/amortization from favorable Section 1231/capital-gain treatment and taxes that portion as ordinary income. Once the depreciation is fully recaptured, any further treatment follows Section 1231.

Practical considerations

• Track accumulated depreciation and the “unrecaptured” portion when planning asset dispositions.
• Depreciation recapture can substantially increase taxable income on a sale—consider timing and overall tax position.
• Because recapture is taxed as ordinary income, consult a tax advisor to evaluate strategies (like structuring sales, exchanges, or installment sales) that may affect timing and character of income.

The bottom line

Section 1245 prevents taxpayers from getting capital-gains tax treatment on amounts that previously reduced taxable income via depreciation or amortization. On sale of qualifying business personal property, the portion of gain equal to prior depreciation is taxed as ordinary income; remaining gain, if any, may receive Section 1231/capital-gains treatment.