Section 1245: Definition, Types of Property Included, and Example (2024)

What Is Section 1245?

Section 1245 is part of the Internal Revenue Code (IRC) that covers the applicable tax rate for gains from the sale or transfer of depreciable and amortizable property. It applies to certain types of real or tangible business property that have been held by that business for more than 12 months.

Section 1245 outlines what properties are included in this treatment and when the ordinary income tax rate applies to their sale, rather than the capital gains tax rate.

Understanding Section 1245

Section 1245 recaptures depreciation or amortization allowed or allowable on tangible and intangible personal property at the time a business sells such property at a gain. Section 1245taxes the gainat ordinary income rates to the extent of its allowable or allowed depreciation or amortization.

What Is a Section 1245 Property?

The IRS defines Section 1245 property as the following:

Section 1245 properties must be or have been subject to an allowance for depreciation or amortization. They can be either personal property (either tangible or intangible) or other tangible property (except buildings and their structural components) used as any of the following:

• An integral part of manufacturing, production, or extraction, or of furnishing transportation, communications, electricity, gas, water, or sewage disposal services
• A research facility in any of the activities listed above
• A facility in any of these activities for the bulk storage of fungible commodities

Section 1245 Recapture Feature

Section 1245 is a mechanism to recapture at ordinary income tax rates allowable or allowed depreciation or amortization taken on section 1231 property. Allowable or allowed means that the amount of depreciation or amortization recaptured is the greater of that taken or that could have been taken but was not.

Section 1245 Background

Conceptually, a lower tax rate on gain means less tax payable and a higher tax rate on loss means a larger offset of taxable income and less tax payable. For this reason, tax planning strategies seek lower capital gains rates for gains and higher ordinary income rates for losses.

Congress enacted IRC Section 1231 to favor businesses by allowing them to apply a lower capital gains rate on gains and a higher ordinary income rate on losses recognized from the sale of their property. However, many businesses had already gotten favorable tax treatment by taking depreciation or amortization deductions on these properties. So, Congress enacted Section 1245 to recapture depreciation and amortization at ordinary income rates on properties sold at a gain.

The wording of Section 1245 implies that it covers a new or different class of property—section 1245 property. But, in reality, section 1245 property is merely section 1231 property that has been depreciated or amortized. Section 1245 property is section 1245 property only as long as it has unrecaptured depreciation or amortization. Once its depreciation or amortization is fully recaptured, it becomes section 1231 property.

Tax Picture of a Sale of Section 1245 Property

If section 1245 property is sold at a loss, it converts to section 1231 property for tax purposes. The loss is ordinary (subject to netting and look-back). If section 1245 property is sold at a gain, it remains section 1245 property. To the extent of depreciation or amortization, the gain is taxed at ordinary income rates.

Once depreciation or amortization has been recaptured, it converts to section 1231 property. Any remaining gain is taxed at capital gains rates.

Example of a Sale of Section 1245 Property

As an example, imagine that a business owns a $100 widget and takes $75 of depreciation. The widget’s adjusted tax basis is its $100 cost minus $75 of depreciation, or $25. The business sells the widget for $150.

The gain is the $150 sale price minus the $25 adjusted tax basis, or $125. Of that $125, $75 (the depreciated amount) is a section 1245 gain taxed at ordinary income rates. The remaining $50 ($125-$75) is a section 1231 gain taxed at capital gains rates.

If the business sells the $100 widget for $20, you have a loss of $20 sale price minus $25 adjusted tax basis, or $5. Since there is a $0 gain, Section 1245 does not apply, and the $5 loss is a section 1231 loss that is ordinary.

The Bottom Line

Section 1245 provides a way to recapture taxes lost on section 1231 property that has depreciated or amortized. It applies toreal or depreciable business property that a business has held for more than one year.

This recapture happens when the business sells certain tangible or intangible personal property. If the business took depreciation deductions on its property, then sold that property for a profit, the gains are taxed at ordinary income tax rates. Once the depreciation or amortization is recaptured, the property becomes section 1231 property, and the remaining value is taxed at capital gains rates.