Why It Matters
Here's what catches investors off guard: when a cost segregation study reclassifies HVAC, parking areas, and appliances into 5-year or 15-year MACRS, those components become §1245 property. Every dollar of depreciation claimed on them gets recaptured at your ordinary income rate — up to 37% — when you sell.
That's a real difference from §1250's 25% cap. Take $80,000 of §1245 depreciation and sell in the 37% bracket: $29,600 in recapture. The same $80,000 under §1250 rules: $20,000. That $9,600 gap isn't buried in fine print — most investors just don't run the exit math before they start the cost seg study.
The primary escape hatch: a 1031 exchange defers §1245 recapture completely. The tax doesn't disappear, but it moves into the replacement property's basis instead of your pocket at closing.
At a Glance
- What it is: Depreciation recapture on personal property taxed at ordinary income rates (up to 37%)
- Why it's harsher than §1250: §1250 recapture on real property maxes out at 25%; §1245 has no such cap
- When it triggers: On sale, exchange, or disposition of §1245 property
- Cost seg connection: Reclassified components (5-year, 15-year MACRS) become §1245 property — all depreciation on them is subject to §1245 recapture
- Main deferral tool: 1031 exchange defers §1245 recapture by carrying basis forward into the replacement property
- Installment sale warning: §1245 recapture is recognized in full in the year of sale — you cannot spread it across installment payments
How It Works
The §1245/§1250 distinction. The IRS splits depreciable real estate into two buckets. Section 1250 covers real property — walls, roof, structure — on the 27.5-year or 39-year schedule. Section 1245 covers personal property: equipment, appliances, fixtures, carpeting, parking lots, landscaping, and any other asset on a shorter MACRS schedule (5-, 7-, or 15-year). Practical test: if a cost segregation study moved it out of 27.5-year into a faster schedule, it's now §1245 property.
The recapture calculation. When you sell, the gain up to the amount of depreciation taken on §1245 property is recaptured as ordinary income. Any gain above your original cost is long-term capital gains at the preferential rate. Your adjusted basis (original cost minus all accumulated depreciation) determines exactly how much recapture you face. Put plainly: everything tax depreciation gave you, §1245 takes back first — at your full ordinary rate.
Cost segregation amplifies exposure. Standard 27.5-year depreciation creates §1250 recapture (capped at 25%). But when a cost segregation specialist reclassifies components into 5-year and 15-year MACRS, those become §1245 property. Accelerated depreciation — especially bonus depreciation that writes off 60-80% in year one — front-loads the exposure. The bigger the cost seg study, the more §1245 recapture waits at the exit.
The installment sale trap. Seller financing can spread capital gains and §1250 recapture across multiple years. It cannot spread §1245 recapture — the full amount is recognized in year one of the sale regardless of cash received. This blindsides sellers who thought they'd engineered a tax-efficient exit.
Real-World Example
Kevin bought a $1.2M commercial property seven years ago and did a cost segregation study in year one. The study reclassified $187,000 of components — HVAC units, parking lot paving, specialty lighting — into 5-year and 15-year MACRS. He claimed bonus depreciation on the 5-year items and accelerated the rest. By sale, he's taken $156,000 of total depreciation on §1245 property.
He sells for $1.6M. Adjusted basis after all depreciation: $763,000. Total gain: $837,000. Of that, $156,000 is §1245 recapture — taxed at Kevin's 32% ordinary rate: $49,920 in federal tax on that piece alone.
Had Kevin kept everything on the 27.5-year schedule, the $156,000 would be §1250 recapture capped at 25% — $39,000 instead of $49,920. The cost seg still made sense on time-value grounds, but §1245 cost him $10,920 more at exit.
Kevin pivots to a 1031 exchange. All §1245 recapture defers. The $49,920 liability moves forward into the replacement property's basis — and if Kevin holds until death, his heirs get a stepped-up basis that wipes it out entirely.
Pros & Cons
- Accelerated depreciation still delivers real tax savings today — §1245 recapture comes later, and time value of money matters
- A 1031 exchange defers §1245 recapture indefinitely, preserving capital for reinvestment
- Stepped-up basis at death eliminates §1245 recapture entirely for long-term holders with an estate plan
- Knowing the rule upfront lets you model the true after-tax exit before committing to a cost seg study
- Recapture rate can hit 37% — no cap, unlike §1250's 25% ceiling
- Installment sales don't defer §1245 recapture — the full amount is due in the sale year
- "Allowed or allowable" rule means §1245 recapture applies even if you never claimed the depreciation
- The bigger the cost seg study and bonus depreciation, the larger the §1245 liability at exit
- Tracking §1245 assets across a portfolio requires clean records — cost basis per component matters at sale
Watch Out
Don't confuse §1245 and §1250 rates. The 25% "unrecaptured §1250 gain" cap only applies to real property. §1245 on personal property components carries no cap. If your ordinary rate is 32% or 37%, §1245 costs materially more than the §1250 math most investors run. Model both before approving a cost seg study.
The installment sale doesn't protect you. Seller financing can spread capital gains across years. It cannot spread §1245 — the full amount is taxed in the sale year regardless of cash received. Reserve enough from closing proceeds or use a 1031 to sidestep it entirely.
"Allowed or allowable" catches skipped depreciation. Even if you never claimed depreciation on a §1245 asset, the IRS calculates your recapture as if you did. Skipping the deductions doesn't reduce your §1245 liability — it just means you overpaid taxes while holding the property.
Annotate your depreciation schedule. Not all cost seg reports clearly flag §1245 versus §1250 assets. Have your CPA label each line before year-end so the exit math is ready when you need it.
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The Takeaway
Section 1245 recapture is the tax bill that arrives when the accelerated depreciation party ends. Every dollar claimed on personal property comes back as ordinary income at sale — no 25% cap, no installment shelter. Cost seg studies and bonus depreciation build §1245 exposure fast. The math still works in most cases because early savings have real time value, but you need to know the exit cost before you start. A 1031 exchange defers it; a hold-to-death strategy through stepped-up basis eliminates it. Model it early and never mistake it for the more forgiving §1250 rules.