Section 1245 Property: A Real Estate Investor’s Tax Guide

Key Takeaways


If you’re a business owner, you’re probably aware that you can depreciate certain business assets to maximize your company’s tax savings. But depreciation might expose you to an additional tax burden: one having to do with any Section 1245 property.

What is a Section 1245 property, and how does it affect your tax savings strategy?


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Section 1245 Property

What is a Section 1245 Property?

According to the Internal Revenue Service Code, Section 1245, a Section 1245 property is any property defined as an intangible or tangible personal property and subject to depreciation or amortization. Buildings and structural components are not included.

You own a Section 1245 property if:

  1. The property plays an integral role in manufacturing, production, and extraction; or providing transportation, communications, electricity, gas, water, or sewage disposal for business operations.

  2. The property is a research facility for any of the activities listed in Item 1

  3. The property is a facility for any of the activities in Item 1, or it’s used for the bulk storage of fungible commodities

[Pro Tip: Fungible commodities are goods that can be exchanged for equal amounts of the same kind—like oil.]

Section 1245 Property Examples

In Section 1245, the term “property” isn’t referring to real estate. It refers to any kind of asset that plays a critical part in a business operation.

Here are a few examples of assets that could be considered Section 1245 properties:

  • Business vehicle

  • Machines that are used to manufacture products

  • Blast furnaces

  • Storage bins for grain (another fungible good)

On the contrary, what’s NOT considered a Section 1245 property?

  • Structural components in an office, warehouse, or factory—like flooring, light fixtures, roofing, HVAC systems, or plumbing

  • Fencing for livestock

  • Wells for livestock

The items listed above are considered “real property,” not personal property. Real property is any asset that cannot be physically moved or which is attached to the land.

Section 1245 properties must be considered personal property, but they also must be used exclusively for business operations.

For example, an employee refrigerator in the office would not be considered Section 1245 property. Although it provides comfort for employees and the business owner, it’s not critically involved in producing company products or services—at least not in the IRS’s opinion.

How Does a Section 1245 Property Work?

You might be wondering, why should I care about Section 1245 properties?

If you’re a business owner, you’re probably looking for ways to reduce your company’s tax burden. Many business owners do this by claiming tax deductions on their company’s depreciating assets. After all, many assets naturally depreciate because of wear-and-tear.

Accounting for depreciation is a good way to save money when you’re filing taxes for your business, but there’s a significant trade-off.

If you have a depreciated asset that you sell for a gain, then the amount you depreciated will be “recaptured.” In other words, you’ll have to pay an extra tax.

1245 Property Gains Tax Treatment

You may have to pay additional taxes on your 1245 property if all of the following apply:

  • You sell the property for a gain

  • Depreciation was taken on the property

  • You held the property for more than a year

If those three rules apply, then you’ll have to pay depreciation recapture.

Section 1245 Depreciation Recapture Rules

Under depreciation recapture rules, the amount of money you depreciated will be taxed at a higher ordinary income tax rate. The rest of the value of your sale will be taxed at a lower tax rate that applies to 1231 properties.

If you sell the property for a loss, then you won’t have to pay depreciation recapture at all—the property reverts to a 1231 property and, like other ordinary losses, is subject to netting and lookback.

Let’s see how this would work in real life.

Sale of Section 1245 Property Example

Let’s say that your business purchases a Tool for $200. You take $150 of depreciation. The Tool now has an adjusted tax basis:

Sales Price ($200) – Deprecation ($150) = Adjusted Tax Basis ($50)

Now let’s assume you sell the Tool for $250.

Sales Price ($250) – Adjusted Tax Basis ($50) = Gain ($200)

Of that $200 gain, the amount you depreciated ($150) is taxed at a higher ordinary income tax rate, while the remaining $50 is taxed at a lower rate for 1231 properties.

What if you sold the Tool for a lower price?

Sales Price ($50) – Adjusted Tax Basis ($50) = Gain ($0)

Now your gain would be $0. The depreciation recapture rules would not apply to your sale.

Section 1245 Property

How To Avoid Depreciation Recapture

The easiest way to avoid depreciation recapture is to not depreciate any of your properties. If you have a property that could be considered 1245 property, then don’t claim any tax deductions on depreciation when you file your taxes. So long as you don’t depreciate, those properties will technically remain 1231 properties—not 1245 properties.

Yes, that means you’ll have more of a tax burden up-front. But you’ll avoid taxes down the road if you ever sold those properties.

Think carefully about your tax planning strategy before you claim depreciation on any properties that could be considered 1245 properties.

Ask yourself the following questions:

Is it better for your business to save money this year? Or would you rather save money down the road? Do you plan on selling your assets at some point? Or will they be unsalvageable?

Another way to avoid depreciation recapture is to sell your depreciated property for a lower price. If you’re going to sell, don’t sell for a gain. You won’t make as much money on the sale, but you’ll also have less tax burden.

[Pro Tip: It’s important to keep all your business receipts—and it doesn’t hurt to have a tax professional in your contacts list, either, who can help you with these tax-important transactions.]

But here’s another thing to keep in mind: it’s rare to sell a depreciated property for a gain. Depreciated property is, after all, depreciated property. It’s older, and it probably won’t run as effectively as it did when you bought it. Chances are, you’re going to sell it for a bargain.

If you have an asset that you’re planning on refurbishing—so you can sell for a higher price—you may want to reconsider that refurbishment if it’s going to trigger depreciation recapture.

The Difference Between a 1245 Property & 1250 Property

So far as accounting goes, there are two methods to calculate depreciation:

  • Straight-Line Method: Dividing the difference between an asset’s costs and expected salvage value. This accounting method evenly spreads the depreciation over the life of an asset.

  • Accelerated Depreciation: This method allows you to calculate a higher amount of depreciation in the early years of an asset’s life so that you can save more money up-front.

Section 1250 of the IRS Code stipulates that you must pay depreciation recapture if you calculated depreciation with the accelerated method, and:

Accelerated Depreciation of the Property > Straight-Line Depreciation of the Property

1245 properties are not subject to this rule—this rule excludes all tangible and intangible personal properties. It can, however, affect real estate investors.

If you’re a real estate investor, Section 1250 may trigger depreciation recapture if:

  • You sell a property for a gain

  • You depreciated the property using the Accelerated Method

  • The Accelerated Depreciation is greater than what you would have saved using the Straight-Line Method

Nonetheless, this is a rare occurrence. The IRS mandates that all homes built after 1986 must be depreciated using the straight-line method. Furthermore, many properties these days tend to appreciate in value—not depreciate.

Still, if you’re a real estate investor and plan on buying older properties, Section 1250 is something you want to know about.

Summary

A Section 1245 property is a personal property that’s a critical tool in a business operation. Section 1245 properties can be depreciated when you file your taxes, but if you ever sell the property for a gain, you may be required to pay depreciation recapture. Depreciation recapture makes you pay a higher tax rate for the amount of money you had depreciated from the property. You can avoid depreciation recapture by opting not to depreciate any properties that could be considered 1245 properties or by selling them at a loss or no-gain.


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